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Diversification: An easy way to reduce risk

Diversification enables you to reduce the risk of your portfolio without sacrificing potential returns by reducing the volatility of your portfolio over time
Md. Harun-Or-Rashid
Diversification: An easy way to reduce risk

Most people would rather save their money in a bank account somewhere than invest, mainly because of the risks associated with investing. In finance, diversification refers to the process of assigning capital in a manner that shrinks exposure to risk. People diversify their investments mainly for three reasons: firstly, minimizing risk of loss; if one investment performs poorly over a certain period, other investments may perform better over that period, reducing the potential losses of investment portfolio from concentrating all capital under a single investment. Secondly, safeguarding capital; not all investors are in the accumulation phase of life, some who are close to retirement have goals oriented towards preservation of capital, and diversification can help protecting savings. Finally, generating positive returns, sometimes investments don’t always perform as you expected, by diversifying you’re not merely relying upon single source for generating income.

Diversification enables you to reduce the risk of your portfolio without sacrificing potential returns by reducing the volatility of your portfolio over time. One of the keys to successful investing is learning how to balance your comport level with risk against your time horizon.

If you invest too aggressively when you’re older, you could leave your savings exposed to market volatility, which could erode the value of your assets at an age when you have fewer opportunities to regain your losses. An efficient portfolio has the least possible risk for a given return. Once your portfolio has been fully diversified, you have to take on additional risk to earn a higher potential return on your portfolio.

To diversify your portfolio, you need to spread your capital across different asset classes to reduce your overall investment risk. These may include a mix of growth assets (shares or properties and generally provide longer term capital gains, but typically have a higher level of risk than defensive assets) and defensive assets (cash or fixed interest and generally provide a lower return over the long term, but also generally a lower level of volatility and risk than growth assets).

For instance, during periods of increased share market volatility, your share portfolio may suffer losses. If you also hold investments in other asset classes such as fixed interest or direct property that may perform better over the same period, the returns from these investments can help smoothing the returns of your overall investment portfolio.

You can also invest in different industries like financial services (banks, insurance companies) energy (oil and gas, pipelines) telecommunication services (telephone companies) health care (pharmaceutical companies) to diversify your portfolio and remain in a comfort zone. To diversify, you need to select stocks whose prices do not move together. Variations in the returns of one stock should offset variations in the returns of other stocks. Remember, stocks within the same industry generally have prices that move together may cost you financially.

Say, you are maintaining a portfolio of a bank and you are opting for purchasing shares of other bank i.e. same industries which will reduce the risk of your portfolio very insignificantly because all banks are might be affected by the same economic conditions, like changes in interest rates. When the shares of a bank drop, those of other banks are likely to drop too. As such, to maintain a balanced diversification of your portfolio, you could add the shares of companies from other industries like telecommunications, healthcare, etc. and subsequently these investments may reward you more conveniently.

And to maintain a balanced portfolio you could buy stocks which give you an opportunity to own a percentage of a company which comes with benefits such as dividend payouts and capital gains when the stock increases in price over time. However, this superior potential for growth carries a greater risk, particularly in the short run because stocks are generally more volatile than other types of assets, your investment in a stock could be worth less if and when you decide to sell. Mentionable that stock should be a significant part of your investment portfolio provided they offer great opportunities for growth in the long-term.

Bonds offer regular interest income and are generally considered to be less volatile than stocks. And act as a good cushion during unpredictable movements in the stock markets as they often behave differently than stocks. Stocks should be a significant portion of your portfolio for an investor focused more on the safety of their investment than growth. However, note that some fixed income investments, like high yield bonds and certain international bonds, can offer much higher yields, notwithstanding with more risk.

Also note that bonds and stocks often move in opposite directions. When investors expect the economy to weaken and corporate profits to drop, stock prices will likely fall and subsequently central banks may cut interest rates to reduce borrowing costs and stimulate spending. This scenario leads to bond prices in upward curve. If your portfolio includes both stocks and bonds, the increase in the value of bonds may help offset the decrease in the value of stocks. Also, remember, the reason for including bonds in a portfolio is not to increase returns but to reduce risk. Your portfolio may also include short term certificates of deposits as well as money market funds which offer stability as well as easy access to investments. Money market funds are conservative investments that offer stability and easy access to your money, ideal for those looking to preserve principal. In exchange for that level of safety, money market funds usually provide lower returns than bonds funds or individual bonds. While money market funds are considered safer and more conservative, however, they are not insured by the government. You could lose money by investing in a money market fund. Although the fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee you it will do so. However, investments such as certificates of deposits are guaranteed by the government making them safer; however, they aren’t as liquid as money market funds.

Investment portfolios with real estate funds which include real estate investment trusts offer protection against inflation. The funds also provide unique opportunities in real estate you wouldn’t otherwise be able to take advantage of on your own. You buy a house as an investment, usually to rent out and capitalize on the rental income. Investing in residential properties has been the most common path for a long term; primarily because investors are drawn to the guaranteed monthly income it produces. Like all investments, investing in real estate can have a lot of upsides. Most of the financial benefits come in the form of tax deductions. Remember, when you own a property, you can’t just decide one day you want to sell it at the close of the market day, like you can with a stock. You can’t back out at a moment’s notice when you’re feeling you don’t want to own the investment. Lack of liquidity is the biggest downfall of real estate investment.

The primary goal of diversification isn’t to maximize returns whereas its primary goal is to limit the impact of volatility on your portfolio. Regardless of your goal, your time horizon, or your risk tolerance, a diversified portfolio is the key safeguard of any smart investment strategy. And diversification acts as bridging to balance risk and reward in your investment portfolio by diversifying your assets. Remember, high risk = high return, but the returns are not guaranteed and low risk = low return but the returns are somewhat guaranteed. And it’s always better to have a mix of high and low return investments.   

The writer is a banker, BBA, MBA (Banking), DU, Certified Finance Specialist

 

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Editor : M. Shamsur Rahman

Published by the Editor on behalf of Independent Publications Limited at Media Printers, 446/H, Tejgaon I/A, Dhaka-1215.
Editorial, News & Commercial Offices : Beximco Media Complex, 149-150 Tejgaon I/A, Dhaka-1208, Bangladesh. GPO Box No. 934, Dhaka-1000.

Editor : M. Shamsur Rahman
Published by the Editor on behalf of Independent Publications Limited at Media Printers, 446/H, Tejgaon I/A, Dhaka-1215.
Editorial, News & Commercial Offices : Beximco Media Complex, 149-150 Tejgaon I/A, Dhaka-1208, Bangladesh. GPO Box No. 934, Dhaka-1000.

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