Diversification and Asset Allocation
Diversification is the process of spreading your investments across a number of asset classes to eliminate some, but not all, of the risk of investing. Suppose you are investing all of your money in real estate stock and if the real estate market crashes, you are losing most of your hard earn money. By diversifying your investment across different sectors like real estate, FMCG, Steel etc. etc. you can avoid some risks.
Most Professionals recommend you own at least one stock in each of the following sectors:
- High yield
- Speculative Stock
- Geographically safe stocks
But How Do You Measure Risk?
Way back in the first Course, we introduced the tug-of-war between risk and return .We saw how the higher the average annual return, the higher the standard deviation (and its companion measure variance) from the average annual return. We have studied the major financial asset classes like Mutual funds, stocks, bonds, “cash” and we discussed the risks and returns of each. Return is easy to measure but risk is very difficult to measure and even harder to anticipate.
Variance & Standard Deviation
Variance and its more useful companion, standard deviation, tell us how much an asset class will vary from the expected return. These measures are readily available from the investment community
For any randomly selected stock on the NYSE, the standard deviation is 49.24%! That means in any one year, many stocks on the NYSE – the most stable stocks! – will vary up or down close to 50% from their annual average return. So how can we reduce the variance? In other words, how can we reduce the risk?
The answer, of course, is to diversify! If we go from 1 randomly selected stock to 2 randomly selected stocks, The standard deviation goes from 49.24% down to 37.36% and If we randomly select 10 stocks, The standard deviation goes down to 23.93%. For 20 stocks, Standard deviation goes down to 21.68%.
But there is a limit to which diversification can reduce your risk in any given asset class (in this case, stocks). The simple reason is correlation.
In the world of finance, a statistical measure of how two securities move in relation to each other is called correlation. Correlation is computed into what is known as the correlation coefficient, which ranges between -1 and +1. Perfect positive correlation (a correlation co-efficient of +1) implies that as one security moves, either up or down, the other security will move in lockstep, in the same direction. Alternatively, perfect negative correlation means that if one security moves in either direction the security that is perfectly negatively correlated will move in the opposite direction. If the correlation is 0, the movements of the securities are said to have no correlation; they are completely random. Imperfect correlation is the key reason why diversification reduces portfolio risk as measured by the portfolio standard deviation.
In real life, perfectly correlated securities are rare, rather you will find securities with some degree of correlation.
Is it still riskier for you? You are a very conservative, risk-averse investor & you don’t like the volatility of stocks. Therefore, you decide to place all your investments into bonds. You will accept the lower return from the bonds in exchange for the lower risk of the bonds. But still it is riskier because, like stocks, Bonds are positively correlated with themselves. They also will tend to do well & do poorly as a whole. But they are often negatively correlated with stocks and Stocks & bonds often (but not always) move in opposite directions. So you can avoid more risk by diversifying your investments across bonds and stocks.
Correlation and Diversification
A combination of stocks and bonds actually created a portfolio with less risk while earning you more return than just bonds. If you are seeking less risk, it not only pays to diversify within an asset class, it pays to diversify among asset classes. The same kind of relationship occurs with domestic and foreign stocks and bonds (although less now than in the past) but diversification is still not a guarantee of positive results. For example no diversification scheme worked well in 2008!
Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon.
The three main asset classes – equities, fixed-income, and cash and equivalents – have different levels of risk and return, so each will behave differently over time
So how much should I have in stocks? How much in bonds? How much of each stock & bond type?”
*Many advisors suggest a formula such as subtract your age from 100 (or 110 or 120). That is the percentage of stocks you should own. The rest should be in bonds. For example a 40-year-old would have 100-40 or 60% invested in stocks and 40% in bonds.
Some of those same advisors that suggest asset allocation also suggest the technique of rebalancing. Rebalancing is the process of realigning the weightings of one’s portfolio of assets. Rebalancing involves periodically buying or selling assets in your portfolio to maintain your original desired level of asset allocation.
Every year, check to see if your percentages are still in balance. If stocks have had a banner year, you might now be at 70/30 instead of your target 60/40 allocation then sell enough stocks and buy enough bonds to bring the balance back to your target 60/40 allocation. Likewise, if stocks have tanked, sell bonds & buy stocks to bring the percentage back up to 60/40.
Stocks & Bonds in Retirement
Many advisors suggest that retirees shed the bulk of their stock investments in favor of bonds and cash investments .The only problem is people are living much, much longer. A 50-year-old living today has a 50/50 chance of living to see 100 years old! So as you near retirement, start migrating your investments from stocks to bonds but don’t abandon stocks entirely!