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Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors.
Before trading, please ensure that you fully understand the risks involved
Trading in financial markets involves significant risk of loss which can exceed deposits and may not be suitable for all investors. Before trading, please ensure that you fully understand the risks involved

Friday, June 01, 2018

Diversification – Portfolio Management tool

By Century Financial in Investing

Diversification – Portfolio Management tool

“Believe me, no: I thank my fortune for it, my ventures are not in one bottom trusted, nor to one place; nor is my whole estate, upon the fortune of this present year: therefore my merchandise makes me not sad.” so said Antonio hundreds of years back in ‘The Merchant of Venice’ written by Shakespeare. Diversification is a concept well understood by humans for a long time, and this is probably true in all aspects of life. Nowhere is the concept more relevant than in asset allocation, since this is closely related to a person’s long-term financial goals.

Why Diversification in Asset Allocation?

Asset allocation at its core talks about diversification and is a strategy that helps in balancing risk and reward. To put it in plain English, there are no sure shots in life; there is always a probability of an event happening or not happening. Consider the case of a person who invested entire savings into a startup venture. In this scenario, the person can either make multiple times original investment or might loss all the wealth if the business goes broke. Or imagine the scenario of an investor, who invested only into photographic film company ‘Kodak’. The person would have lost all savings as photography transitioned into Digital mode and Smartphones. Disruption is the rule of life as Encyclopedia are replaced by Google, Travel Agents by online sites like Booking.com, Hotels by Airbnb, Taxis by Uber, Cable Television by Netflix, etc. In a fast-changing world where transformation happens at the speed of light, a business going bankrupt cannot be ruled out. Hence it would always be prudent on the part of the investor or even a trader to not place all bets in one investment scenario. No wonder, our old timers always used to say “Don’t put all your eggs in one basket”.

Diversification is a key to neutralize losses in a portfolio when crashes occur. First of all, it is always fruitful to manage your savings and strategically invest in different asset classes. Today the entire world functions as an interdependent structure of supply and demand. Not only the share markets in Dubai but across the globe, stocks also are very volatile by nature and pose high risks, as in the case of a sudden crash. Therefore, it is always wise to diversify your investments across different asset classes as well as geographically across different markets.

Diversification and Modern Portfolio Theory

For a long time in the stock market, it was believed that returns could be maximized only thorough analysis of companies and then concentrating investment into these securities. This belief was broken in 1952, by Harry Markowitz with the introduction of his seminal work on Portfolio Selection, “Modern Portfolio Theory”, which upended all conventional wisdom in the field of investment. His theory suggested that risk-averse investors could construct portfolios to optimize or maximize their return at a given level of risk and also reduce risk by investing in more than one stock. For example, an investor having two stocks will be having lower risk than that of holding the individual stocks.

“Modern Portfolio Theory” is one of the most important theories dealing with investment and for his work Harry Markowitz was awarded Nobel Prize in Economic Sciences in 1990. Needless to say, the concept of asset allocation gained prominence in the field of finance due to work of Harry Markowitz.

How to Diversify?

Assets can be classified into different categories like Equities, Commodities, Bonds & Forex and each serves its purpose. Certain asset classes will perform well under certain conditions and diversification ensures that the investor doesn’t miss out on these opportunities. Global equities are a vast space comprising of Developed, Developing and Emerging Market countries. Technological advancement today enables investors to access thousands of equities across America, Europe, Japan and Hong Kong with one single click. Diversification today is more easily possible, than at any other point in time. From Dubai itself, we can access different markets and different asset classes including bonds, currencies and commodities as well.

Commodities are the best hedge against inflation, and they have low to negative correlation with other asset classes, which helps in proper diversification. With inflation rising across the globe, commodities are an interesting investment proposition. Even a geo-political event like the conflict in North Korea or Iran will increase volatility in the markets and cause a rally in safe-haven assets. Investors flock to bonds or a currency like Japanese Yen in uncertainty or during market fall as they are considered to be safe-haven assets, which make Bonds a vital component.

Therefore it is always advisable for investors to design their portfolio in a manner that a certain amount of their wealth is allocated into safe-haven assets like gold, silver, etc. which acts as a protection against market dips. The diversification rule also stands true within the equity portfolio. Every sector or industry isn’t impacted in the same way during a pullback, and that is why if a certain portfolio is well diversified and monitored, losses can be managed to a great extent. One can also shift equity investments into higher-quality or blue-chip companies while looking to diversify internationally and domestically. The share market in Dubai particularly consists of various sectors ranging from real estate to banking to energy – burgeoning off late, providing ample opportunities for investors to enter the market as well as diversify their wealth into various industries.

Asset Allocation Styles

There are different sets of classifications, but conventionally Asset Allocation of portfolios are classified into three different categories,

As the name suggests, Aggressive Portfolio is for those investors who are looking for higher return or who are willing to take high risk. For the aggressive portfolio, 70% allocation is given to higher risk securities like stocks, commodities, FX while 30% is given to low-risk products like bonds and income products. This style of investment is suitable for young as well as affluent individuals who can take high risk. A balanced portfolio has an equal mix of high-risk and low-risk securities while a defensive portfolio has 30% weightage of high beta and 70% low-risk securities. Balanced Portfolio is suitable for middle-aged individuals while retired persons would be advised to go for a defensive portfolio.

All of these arguments make a strong case for a diversified portfolio in asset allocation and as Harry Markowitz once said diversification is “the only free lunch in finance.”