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4 Important Factors to Diversifying Your Portfolio

Updated: Mar 28, 2023

Diversifying risk is in large the most important tool at an investors disposal. When executed well, diversifying allows the investor to allocate capital in a manner that reduces exposure to one particular asset or asset class. The general idea is that during times of economic contraction, some capital markets move in correlation with each other and some have a negative correlation (ie: move in the other direction). When developing a strategy that fits your personal needs, goals and tolerances, efficient capital allocation should be the first thing an investor considers as essentially it is a review on risk; 'Putting all your eggs in the same basket' is a common phrase that simplifies the theory of diversification. Sure, higher returns are merely a compensation for higher risk, however professional investors focus far more on risk than your average investor. But how do they do it?

1) Pay attention to Correlation

Correlation is a coefficient that represents the relationship between two assets where a perfect correlation of +1 would show that both assets move identically. Professional investors are always considering correlation as it plays a crucial role in portfolio management. For example: an investor who is long on equities may also want to consider also buying gold as there is a negative correlation between the two markets. This is because gold is commonly known as a 'safe haven' asset so when equities are selling off, the accumulating losses in equity positions will be at least partially offset by rising gold prices. A further example of correlation in financial markets is with oil prices and airline stocks, an obvious observation as oil prices can drastically change profits for companies relying heavily on the commodity. Investments in emerging markets can offer low correlation with developed markets therefore reducing portfolio correlation risk exposure. However, other risk factors such as economic, political and government risks should be considered with emerging market investments.

2) Rethink Your Time Horizon

The saying 'patience is a virtue' has never been truer when considering investment decisions. Investors are generally aiming to outperform the market within a very short tine horizon. This may be possible for experienced active investors who utilise several strategies of trading and investing however generally it can be difficult to achieve. It would be sensible to realise that value investing takes time to materialise, just take a look at the worlds more famous investor Warren Buffet.

3) Stay Current With Events

Albeit value investing takes time to develop, it doesn't necessarily mean you should just ignore them and leave your portfolio on autopilot. It would be wise to keep up to date with financial news from the broader market and in particular your assets, also the correlated markets which have an impact on your holdings ie: oil prices and airline stocks.

4) Stick to Risk Parameters

Professional investors focus a-lot of attention on portfolio exposure rather than just potential returns. Everyone knows someone who has had a bad experience in the markets, most likely as a result of poor capital allocation or high risk exposure. However there are risks associated with any investment, wether it be a business, property or financial asset, the key is make educated judgements on downside potentials. For implementing a solid risk strategy, it is crucial to have an exit plan. At what stage do you cut you losses or perhaps hedge against further downside. Without having this mapped out it is more than likely that normal investor behaviour will take control and decisions get blurry. Furthermore it is a key element into understanding risk:reward ratios for your portfolio, for example: would you risk $10,000 for an expected return of $1000. It doesn't matter what instrument you trade with or wether you use leverage, having good risk:reward and a solid exit plan is undoubtedly the most important variable into dictating future returns. Granted, this is a greater concern for active investors as passive or value investors buy shares into large popular companies that can withstand a bit of drawdown. If your investment strategy is to buy into value stocks with a long time horizon then perhaps your main risk considerations evolve around simple diversification and correlations ie: spread your money out.

Final Thoughts

Good portfolio diversification is an essential element to building a solid and sustainable investment plan. The last two decades has shown us the financial crisis and more recently Covid pandemic, both of which has massive implications on the financial markets. Some assets have recovered better than others after initial panic selling, however applying some of the tips above can help eliminate some emotions that come with investing and often result in poor decision making.


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