Friday, March 6, 2009

Introduction to diversification

Diversification is by far the most important strategy that an investor must learn. It is similar to the old saying "do not put all your eggs in the same basket". It is so obvious that if someone will tell that to you you would offended.

What is Diversification?
Diversification is when you invest in a range of investment instruments that are different from each other. Diversification is done because each instruments have different risk, volatility and liquidity associated with them. Hence by investing in instruments have have different risk, your portfolio is more resilient to shocks in the economy. If the value in some investments decline, the fall might be balanced by rises in others or at least the value of the other investment might not fall as much and as a result the value of your portfolio will not fall as much.

Lets say that you invested in one stock, then in a recession the value of your portfolio will fall with the stock market. However if you buy two stocks, then one of them might fall less and reduce the fall. Consider further that you have used a third of the money to buy bonds. In a recession the value of the bond will be the same. Hence your portfolio will be further able to resist the fall of the stock market. hence as you can see it is a usual practice to have in your portfolio a mix of bonds, stocks and cash. The cash is used to meet emergency expenses so that you don't have to sell bonds and stocks. It is never a wise move to sell stocks of bonds to meet unexpected expenses. Hence a typical portfolio will have a mixture of bonds, stocks and cash. The more aggressive investors will have a larger percentage of stocks while the safe investor will have a larger percentage of bonds.When creating a portfolio that contains both stocks and bonds, aggressive investors may lean toward a mix of 80% stocks and 20% bonds while conservative investors may prefer a 20% stocks to 80% bonds mix.

You should also keep in mind that stocks come in different flavors. There are blue chip companies, medium and small size companies and start-ups that offers varying degree of risk and return. Investors can buy stocks from different sectors of the economy. Remember that different sectors of the economy are not affected in the same way during recessions. some may even be counter cyclical and rise during a recession. It is thus important to include in your portfolio stocks that are from various sectors and from companies of different sizes.
Bonds are also of various types. Bonds may be from governments, companies and municipalities. These bonds have different risks and hence have different returns. They also have different maturity dates so that if you are building a bond ladder with a bonds of maturity dates then you will have bonds that mature every year. It is therefore a good practice to have different types of bonds that have different returns and different maturity dates.

If however you do not want to go to the expense of buying all sorts of stocks and bonds you could buy a mutual fund. Mutual funds are a selection of bonds and/or stocks have have been bought by a company and you got to buy a share of them. You thus invest in the mutual fund and you get the advantages of buying stocks and bonds. Mutual funds comes in all types of flavors. you can have all stocks, different mix of stocks, all bonds, different types of bonds and different mix of bonds. The choice is all yours. You can also have index funds that buy mostly everything so that you benefit from the general trend. The choice is yours. Mutual funds are ideal for those that are starting in the investment world or don't have time to do research. However for the expert investor mutual funds is not advisable for with time the fees eat the profit.

While stocks and bonds represent the traditional investment instruments, a lot of alternative investments can be used for diversification. Real estate investment trusts, hedge funds, art and other investments provide the opportunity to invest in vehicles that do not necessarily move in tandem with the traditional financial markets. I do not however recommend them for they require a lot of professional knowledge.

A word of caution is required here. While diversification is good for the investor, there is also what is called overdiversification. At this point fees increases to such an extent that it decreases the return. Tracking the inverstments is time consuming. So you should not diversify into too many investment instruments.

Your personal time frame, risk tolerance, investment goals, financial means and level of investment experience will play a large role in choosing your diversification strategy. Start by making a financial plan and choose the appropriate mix.

Good luck.

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