‘Asset class diversification is quite important to reduce portfolio risks.’ ‘Diversification may guarantee you higher returns.’ You might often hear these phrases from investors. Prima facie, it may look to diversify your investments which could increase the time and effort in managing them and performers and non-performers will nullify each other. So how exactly does diversification help in reducing the portfolio risk?
What is an Asset Class?
Asset class is basically a group of investments which exhibit similar features. These investments can further be broken down into sub-categories or sub-classes on basis of their size, industry, location etc. Each asset performs differently in a particular market and reflects different risk and returns characteristics. Broadly they are classified into
- Equities or stocks
- Fixed income or bonds
- Cash and cash equivalents
- Alternative asset classes
Equities or Stocks
Equity basically means owning a piece of a company you invested in. It represents an ownership stake in a company and these are also known as stocks. They have a key place in a portfolio as they promise the highest return over time but they also carry the most risk. When you invest in a publicly traded company, you get a share certificate that comprises the number of shares you own and serves as a proof of your ownership. Apart from identifying and investing in the companies you wish to, you need to consider several other factors like what kind of stock ownership benefits you, the purpose you want the returns to serve. In the long run, equities are known to earn higher and more consistent positive returns than any other financial investment.
Fixed Income or Bond
A bond is a formal contract to repay borrowed money at a fixed rate of interest along with the principal at a specified future date. It provides the borrower with external funds to finance long-term investments. They have a creditor stake in the company, which makes them lenders or creditors. In other words bondholders do not own a portion of the company. Typically, people like to invest in bonds because they are less risky and pay steady and regular interests, providing a predictable stream of income. You can invest in bonds if you are looking for regular income and want to preserve your capital investment.
Cash and Cash Equivalents
A cash investment is a short term commitment that provides returns in the form of interest. Examples of cash equivalents include negotiable instruments such as treasury bills, commercial papers and certificates of deposit and it is used by many participants, including banks and companies, to secure funds by selling commercial papers in the market. Investors, who opt for this kind of investment, benefit from its high liquidity and low-risk yield.
Alternative Asset Classes
There are considerably more alternative asset classes. These include assets like real estate, commodities, international investment, bitcoin, hedge funds, precious metals, agricultural land, machinery and oil etc. When popular asset classes fail to perform people prefer to invest in alternate asset classes The flip side to this is that normally, more unconventional the investment, lower the liquidity which means although the returns on these investments can be liquidated, it might take more time to find a buyer to liquidate them.
One school of thought is more inclined to concentrate on a specific asset class as investments in one asset class manifest similar characteristics and subsequently tend to have a similar cash flow. This way the investment process is easier to manage and control. Investors leaned towards assurance on their returns more than maximizing them are inclined towards this idea.
But one needs to diversify the asset class to maximize returns while reducing the risk on portfolio.
What is Diversification?
In Finance, diversification is the process of allocating the asset classes in a way that reduces the risk. It allocates the investment among various financial instruments, industries and other categories. Think of it as putting your eggs in different baskets, where each basket acts differently to a given situation.
Benefits of diversification across asset classes
When you invest in a combination of asset classes, your overall portfolio is less exposed to suffer during market swings. For instance equity and bond markets move in opposite directions. This implies if one falls, the other will rise. Diversify your assets by dividing them among the four categories mentioned above (stocks, bonds, cash and real assets). Each asset class has different levels of risk and return, so each will react differently over time.
The position to avoid is having equal number of investments across all asset categories. This way, you may be inclined to performing and non-performing assets offsetting one another. For this, you need to be sharp and mindful to the markets and disperse your money accordingly.
How do I diversify my assets within the asset class?
There is no formula for knowing which asset allocation will assure 100% success. But there are a few things good to consider before beginning the allocation process:
1) Diversifying the assets in short and long-term bonds, or in high and low-risk stocks is more important than which stock or which bond to invest in.
2) Mark out your life goals before sitting down to allocate your assets. It could help you decide which mix will be beneficial for you in the short and long run.
3) You need to meticulously weigh the difference between return and risk in order to become a successful investor. Everyone wants the highest possible returns on their investments, but simply playing the stock markets is not always going to work for you. Always keep an eye on the fluctuating market patterns.
4) If you already have an existing portfolio, don’t hesitate to revamp it if necessary. There is always time to add new and diversified investments.
5) Instead of relying completely on financial planners, do your own research because financial planners might put you into a standard plan and not necessarily what is best for you. But you are the best person who knows everything about your need & wants and your risk appetite. It is therefore important to study about the Investment and understand the market.
6) The trick is to have a portfolio that consists of a smart mix of investments, giving you a good opportunity to play safe and take risks at the same time. The more uncorrelated your investments are, the better.
Liked this content? Check out more: