Achieving Optimal Portfolio Diversification

Diversification is a growth strategy that capitalizes on market opportunities by allocating investment risk over different asset classes in the aim of counterbalancing losses from one asset with the gains of another asset. Although within a balanced portfolio there may exist low correlation of returns between private equity and other asset classes, diversification leverages investment risk.

The "Don't Put All Your Eggs in One Basket" Rule

Savvy investors diversify their portfolios by investing in different classes of assets including stocks, mutual funds, bonds or cash. The "don't put all your eggs in one basket" rule is extremely helpful in efficient investment decision making. Even if you have high conviction on a particular investment, still you want to control the risk you undertake and have an exit strategy in case this idea fails to meet your investment goals. By constructing a well-diversified portfolio, you protect your investments but you also allow potential for growth. By using the proper asset allocation, you can leverage investment risk and portfolio volatility because each financial asset is expected to react in a different way under dissimilar market conditions.

Evaluating the Risk of Financial Assets

Different financial assets incur different investment risk. In particular:

• Stocks

Stocks are financial assets of equity investing that offer to investor ownership (share) of the company. Stocks are widely regarded as the riskiest of all financial assets because they are directly related to the stock market. The sharper the market fluctuations the higher the risk incurred.

• Mutual Funds

Mutual funds are collective holdings of varied asset classes that belong to the same portfolio of many individual investors. By holding mutual funds, you hold a portion of that portfolio of diversified stocks that cost less if purchased collectively than if purchased individually. Due to their extent of diversification, mutual funds are considered less risky than stocks and generate lower but safer returns.

• Bonds

By investing in bonds you get compensated with a fixed interest rate for lending money to the government. Bonds are safer investments both than stocks and mutual funds because they do not incur any inherent risk associated to market collapses. Bonds typically experience short-term price fluctuations and generate higher long-term returns. However, bonds incur inflation risk and are inversely related to interest rates, becoming riskier on a long-term horizon.

• Cash

The value of a certain amount of money today will not be the same in one year due to inflation. If you invest today $100 with an interest rate of 8%, the value of $100 in one year will be $108. However, the purchasing value of $108 in one year may be less than today due to higher inflationary pressures. For profitable cash investing you have to surpass inflation rates.

Achieving the Optimal Portfolio Diversification

Optimal portfolio diversification considers the relationship between risk and return, known as the efficient frontier. The efficient frontier identifies the best return that you can expect for a given level of risk or the lowest level of risk required to achieve a given expected rate of return. Put simply, an optimal portfolio has the highest expected return possible for the given amount of risk.

To achieve optimal portfolio diversification you should primarily to include investments from different industries, sectors and geographical regions. By diversifying portfolio mix with industry and sector allocation and geographically diverse exposure, you can leverage portfolio risk.

Secondly, include investments that incur different level of risk. Different investments with different expected rates of return are mole likely to offset the losses of your portfolio.

Thirdly, in regards to equity investing, include on average ten to twelve diversified stocks from different industries, sectors and geographical regions.

Finally, check the standard deviation of your diversified portfolio. Your goal is to have a portfolio standard deviation lower than the average standard deviation of each individual asset. This would mean lower portfolio volatility.

Conclusively, portfolio diversification is a good investment strategy. However, to achieve optimal portfolio diversification you have to take into account the existing market realities in order to effectively assess the relationship between risk and return. In times of financial uncertainty, savvy investors diversify their portfolios by investing in less risky investments that generate long-term and safer returns.

Sources:

http://www.ezilon.com/information/article_16406.shtml

http://www.finweb.com/investing/bond-risks.html

http://www.investopedia.com/terms/e/efficientfrontier.asp

http://moneyterms.co.uk/efficient-frontier/

http://www.investopedia.com/terms/s/standarddeviation.asp

More from this contributor:
The Importance of Asset Allocation in Managing Investment Risk
How to Create a Stock Portfolio
How Finance Professionals Calculate Risk for Investments