This question could extend to business sectors as well as individual companies, of course, for diversification is not complete unless investment is spread across different sectors and then across different companies within those sectors. The case for diversification Much investment theory hangs on minimising inherent investment risk. Not all assets move in the same direction, or at the same pace, at the same time. Asset diversification removes the risk of being invested in the wrong asset at the wrong time, and negates the need for premium market timing.
Typically this involves identifying how much of the portfolio should be distributed into various asset classes, or broad types of investments such as stocks, bonds, commodities, and cash.
Evidence exists that suggests certain asset classes perform better or worse depending on economic conditions, market forces, government policy, and political influence. The goal of an asset allocation strategy is to identify these conditions and allocate resources appropriately.
Asset allocation, however, is principally concerned with allocating capital into different asset classes. Diversification is typically associated with the allocation of capital within those asset classes.
The concept of diversification involves the distribution of assets within individual asset classes — while risk is distributed among the asset classes of the overall portfolio, diversification reduces risk within each asset class.
Figure 1 History of Asset Allocation Utilizing asset allocation strategies as a form of risk management is not a new concept. Yet, the term asset allocation did not exist within the investment community until recently. That conception of asset allocation as a fact of life stayed relatively unchanged until the middle of the 20th Century.
Figure 2 So what changed to create the asset allocation models that we are familiar with today?
After Markowitz created his mathematical models for portfolio construction, his ideas quickly became accepted in academic circles.
A vast amount of research was published verifying the benefits of asset allocation and it rapidly became popular among financial professionals as well.
After ERISA became law, asset allocation and modern portfolio theory became standard practices for portfolio managers required to be in compliance with the Act when allocating investor capital in pension plans. The concept of MPT is fairly straightforward. However, it does require that the investor makes several assumptions about the financial markets; additionally, the mathematical equations used to calculate correlation and risk can be somewhat complex.
The basic premise of MPT is simple: In other words, combining assets that are not correlated will produce the most efficient portfolio — the portfolio that produces the greatest return for a given amount of risk.
Asset returns do not have to actually be negatively correlated or even non-correlated to provide the benefits of diversification, they just cannot be perfectly correlated. For example, in the chart below, international stocks as represented by the EAFE index are compared to U.
Using the Correlation Coefficient indicator you can see that the correlation is positive for most of the five-year time period. However, it is not perfectly correlated that is, a correlation coefficient of 1.
Figure 3 There are periods of low correlation and even negative correlation contained within this time period. By investing in both U. The concept of MPT illustrates that adding a volatile asset to a portfolio can still decrease overall volatility if the returns have differences in correlation.
This is an intriguing concept — that overall portfolio volatility can be decreased by combining asset classes together that, by themselves, have returns with higher volatility. The assumption is that, by combining asset classes which are not perfectly correlated when one asset is declining in value, another asset in the portfolio is increasing in value over the same time period.
So even if all asset classes are by themselves highly volatile, when combined together in one portfolio the volatility is reduced.
An extreme example of negative correlation is shown in the following chart of the U. Dollar compared to the price of Gold over the last five years. If an investor would have been invested in these two volatile assets together, the overall volatility of the portfolio would have been lowered significantly due to the negative correlation.
Diversification is a tool used by financial professionals to help investors create a portfolio focused on achieving their goals and dreams, without exposing them to undue risk. Style Focused Market Neutral ETFs At the bottom of the list are funds that take advantage of a single factor or theme. For instance, the fund might buy small-cap stocks and short large-cap stocks. Investment Style Focused on Risk Diversification Words | 10 Pages. Diversification, Schmiversification Steve Smith, 23, recently out of college, has just won $15 million in the lottery.
Figure 4 As mentioned earlier, MPT requires that the investor makes certain assumptions about the financial markets in order to calculate the potential benefits of the theory.
The major assumptions are that… Financial markets are efficient. Market returns are randomly distributed. These assumptions are necessary for accurately calculating standard deviation and correlation using a normal distribution, or bell curve.For over 20 years, the Voya Investment Management Senior Loan Group has delivered to institutional and individual investors a dedicated style focused on loss avoidance with an emphasis on diversification and liquidity.
Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The process of determining which mix of . In his research, Steve has found that there is a commonly accepted investment style that is focused on diversification of risk.
Risk in terms of investing is based on the possibility of losing your money. Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The process of determining which mix of . Investment Style Focused on Risk Diversification Diversification, Schmiversification Steve Smith, 23, recently out of college, has just won $15 million in the lottery.
After buying a few things, he realizes that he still has quite a bit of money, and starts to look at the big picture and what he should do. Diversification is a technique that reduces risk by allocating investment among various financial instruments, industries and other categories it aims to maximize return by investing in different arias that would each react differently to the same event.