Diversification Beyond Equities

by Investopedia Staff, (Investopedia.com)

If there’s one thing that even the newest investor understands, or has at least heard of, about a portfolio it’s diversification — blending a variety of asset classes to reduce exposure to risk. What we’d like to illustrate is how a well-diversified stock portfolio is just one component in attaining a much larger asset portfolio.

In this article we will look at how diversifying among different assets, an investor mitigates risk. Even with a well-diversified stock portfolio an individual is still exposed to market risk (or systematic risk as finance professors like to call it) which cannot be diversified away by adding additional stocks.

We will show that to have a truly diversified portfolio of assets, an individual must invest in different asset classes and thereby reduce exposure to the risk inherent in holding just one asset class.

What Exactly Is Diversification?

Basically diversification among various asset classes works by spreading your investments among various assets (e.g. stocks, bonds, cash, T-bills, real estate, etc.) with low correlation to each other; you reduce volatility by the fact that different assets move up and down at different times and at different rates. Thus having a portfolio diversified amongst different assets offers an individual the ability to realize greater consistency, overall portfolio performance and less volatility.

How Does Correlation Work?

Correlation works fairly simply, and a basic understanding of it will be needed for the purposes of this article. If two asset classes are perfectly co-related they are said to have a correlation of ‘+1’. They would move in lockstep with each other, either up or down. A completely random correlation — a relationship wherein one asset’s chance of going up is equal to the chance of dropping if the other asset rises or falls — is said to be a correlation of ‘0’. Finally if two asset classes move in exact opposition — for every upward movement of one there is an equal and opposite downward movement of another, and vice versa — they are said to be perfectly negatively correlated, or have a correlation of ‘-1’.

Below is an illustration of the degree of correlation between different asset classes and the S&P 500; this should provide an idea of what we mean when we are referring to diversifying your portfolio amongst assets with low correlations.

A Diversified Stock Portfolio vs. A Diversified Portfolio of Assets

When we talk about diversification in a stock portfolio, we’re referring to the attempt by the investor to reduce exposure to unsystematic risk (i.e. company-specific risk) by investing in various companies across different sectors, industries or even countries.

When we discuss diversification among asset classes the same concept applies, but over a broader range. By diversifying among different asset classes you are reducing the risk of being exposed to the systemic risk of any one asset class, in other words the risk that diversification within an asset class, such as stocks, cannot eliminate.

Like holding one company in your stock portfolio, having your entire net worth in a portfolio of any one asset — even if that portfolio is diversified — constitutes the proverbial “all of your eggs in one basket”. Despite the mitigation of unsystematic risk (risk associated with any individual stock) you are still very much exposed to market risk. By investing in a number of different assets you reduce this exposure to market risk or the systemic risk of any one asset class.

Most investment professionals agree that although diversification is no guarantee against loss, it is a prudent strategy to adopt towards your long-range financial objectives. (see The Importance of Diversification.)

How to Diversify Your Portfolio

To this point we have talked more in a theoretical sense. Now, let’s look at some examples to sink your teeth into. Bonds are a popular way to diversify due to their very low correlation with some of the other major asset classes, particularly equities. Other fixed-interest investments such as T-bills, bankers’ acceptances and certificates of deposit are also popular.

Another viable option is real estate, which has proven its worth during various stages in the economic cycle, and has a relatively low correlation with the stock market. Using real estate as an asset to diversify a portfolio is an excellent and practical investment largely due to the fact that many people (through their homes or otherwise) are invested in the real-estate market.

Real Estate as an Option

It’s amazing how many people tend to overlook the investment potential of this asset. Investing in real estate doesn’t mean that you need to go out and purchase a house or building, although that is a viable option for entering this market.

As an alternative to a direct property purchase, individuals can invest in the real-estate market through real estate investment trusts, or REITs. REITs sell like stocks on the major exchanges, and they invest directly in real estate through properties or mortgages. REITs typically offer investors high yields as well as high liquidity. Because of the real-estate market’s relatively low correlation with the stock market, by investing in a REIT an individual is able to diversify away some of the risk inherent in the stock market from their portfolio. (To learn more about REITs, please see What Are REITs and The REIT Way.)

Real estate, and more specifically REITs, is just one of the means to accomplish this reduction in exposure to risk. As the illustration above demonstrates, investors have a number of different options that all act in such a way to reduce the risk of investing in any one asset class.

Conclusion

Diversification is a key building block to anyone’s financial plan, including the understanding of what precisely diversification does and how it helps an individual’s overall financial position. It is crucial that investors know the difference between systematic and unsystematic risk, as well as understand that by diversifying among asset classes they can mitigate exposure to systematic risk.

Sincerely,

Barry B. Guca

www.LasVegasGreatHome.com