One of the most fundamental aspects of asset management that investors need to understand is the importance of diversification. A properly diversified portfolio will continue to generate income regardless of market conditions. In other words, when one asset class underperforms, another will hopefully improve its performance in order to balance out the losses.
The Two Primary Approaches to Diversified Investing
When it comes to asset allocation, investors need to think about diversification in two ways. First, they should diversify across asset classes, which means investing in a variety of different types of investments, such as stocks and bonds. Then, individuals need to diversify within a specific asset class. This concept is perhaps slightly more difficult to understand. Within a particular asset class, such as stocks, different industries will perform better under varying market conditions. For example, in an economic downturn, an entertainment company may suffer, but a tech startup designed to connect people to jobs may actually perform very well. When it comes to diversification within a certain class, investors need to think strategically about how to balance market demand and must keep in mind that it usually takes about a dozen stocks to achieve true diversification.
Keeping Vigilant about New Correlations Between Markets
One of the truths that can prove frustrating to investors when it comes to diversification is that correlation between classes often changes over time. A classic example of this sort of shift in correlation involves international markets. Many investors have used international markets to diversify their portfolios. When some markets began to fall flat, others would generally pick up, which made this strategy a solid one. However, over the years, the correlation between global equity markets has become stronger due to events such as the formation of the European Union. Many emerging markets have become correlated with those of the United States and the United Kingdom. As a result, many portfolios designed to mitigate against losses in one country have actually resulted in a series of devaluations that deflate a portfolio.
Another example is the more recently identified correlation between the fixed-income and equities markets. Some industry experts believe this relates to a growing relationship between investment banking and structured financing. However, others point to the hedge fund industry as the larger driver of this correlation. When a large, multi-strategy hedge fund experiences losses in a particular asset class, margin calls may force the organization to sell other assets, which in turn affects the other classes in which the company has invested. Regardless of the cause, the point is that investors need to remain vigilant about their diversification as relationships between assets change. The same diversification strategy from 20 years ago may not hold true today.
Using Asset Allocation to Maintain Proper Diversification
Fortunately, asset allocation does not need to be static. In fact, investors should regularly re-evaluate their strategies and change them, if necessary. As markets develop, an imbalance between classes can start to become apparent, which should be as much cause to realign as identifying new correlations. When rebalancing a portfolio, it can prove tempting to divest from underperforming assets and move all the funds to an asset class that generates high returns, although this can result in putting too much money in a single type of investment. This may become problematic because an extended bull market can encourage overinvesting in an asset class overdue for correction, which could mean a loss of money. Realignment should typically take place at both ends of the performance spectrum.
Automatic Diversification Through Mutual Fund Investments
Since true diversification requires such a large number of investments and vigilance in watching the market, many individual investors find it easier to achieve this through a mutual fund. A mutual fund is essentially a company that pools money from several different investors and then reinvests it. Through a mutual fund, individuals can take advantage of diversification while buying a fewer number of shares altogether. Different mutual funds will have varying focuses. While some will invest across a variety of asset classes and diversify within them, others may focus on a particular class and achieve diversification within that particular type of asset. Since mutual funds are not all created equal, investors need to undertake a lot of research before investing to ensure that the particular option meets their individual needs. Furthermore, it may make sense to invest in multiple mutual funds at once as a further diversification strategy, particularly if one focuses on a particular asset class.