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Diversification is not just putting eggs in different baskets


Is your portfolio really diversified?

Are you putting your eggs in different baskets but in the same truck?

Do you know where your portfolio stands in the risk return scale?

Diversification misconceptions

There is a common analogy that is frequently quoted to explain investment diversification "don't put all your eggs in one basket" which implies putting eggs in different baskets to spread out the risk yet beware as it doesn't tell you the full story.

Diversification is normally quoted as an investment risk mitigation strategy but it's not just a matter of putting eggs in different baskets, it is a matter of finding baskets which are negatively correlated to each other.

There are different schools of thought on the topic but in essence the strategy involves finding assets whose value moves in opposite directions. As one increases in value, the other decreases in value.

While you do jeopardize returns you also mitigate risks. This way you won't be as worse off or as better off but you will at least get the average.

Theoretically through this strategy you can improve the risk/return metrics, as you can achieve more consistent returns throughout the investment term. However, this goes down to quantifying matters and it is easier said than done.

If you hold a portfolio of 100 stocks and argue that your portfolio is diversified for this reason, beware as you might not be diversifying risk as much if they all sit within the same industry, market or country, as they are all likely to be influenced by similar factors and variables, hence your portfolio might carry concentration risk.

If you are trying to replicate an index thinking that you will have a diversified portfolio as it will give you exposure to a big number of stocks, remember that most indexes are built to track markets they are not investment portfolios constructed with diversification and risk mitigation in mind.

Putting your funds in many baskets doesn't necessarily mean that you are diversifying your money as for that purpose the baskets need to be negatively correlated to each other.

Unless there is correlation consideration, your portfolio might not achieve diversification, you might be putting all your eggs in different baskets but in the same truck which won't reduce risk as much.

Returns do not tell you the full story either

While you often hear investors boasting the returns they have achieved, don't forget to ask them how are they tracking in the risk return scale.

If you want to assess performance you need at least two parameters, comparing this to running you need distance and time.

In Funds Management, I would say that the bare minimum starting point is risk/return.

If investment risk within the overall portfolio is not being quantified, you might be absorbing too much risk and those returns that you were proud about could evaporate over night.

Even a sharp ratio comparison examination might give you a better idea on how the portfolios stacks against other portfolios in terms of returns and volatility /risk exposure, but to do such comparison you must first quantify volatility.

Do you know where your portfolio stands in the risk return scale?

Does Active Management mean more risk?

Assuming that all actively managed funds are inherently more risky purely because they are trying to beat an index benchmark is in my opinion a dreadful assumption that could bias investors to discard great investment opportunities.

Some of them place a strong focus in risk and diversification and will not expose you to unnecessary market risks if needed just to bring your returns over a benchmark and they could constantly produce better returns under a risk/return scale.

Hedge funds or actively managed mutual funds may also serve to create less volatile/risky portfolios than a benchmark index.

I don't mind not beating market returns if that makes more sense from a risk return standpoint.

There is more to investments than meets the eye and plenty of factors to consider when making investment decisions.

Investment decisions can have a critical impact in life, when in doubt make sure you get expert advice.

The information contained in this article does not take into account your personal circumstances. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice.

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Strategic View Point by Carlos Mauleon Senior Manager of Strategic Business Initiatives at BIZNEX Consulting www.biznexconsulting.com.au

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