Building Wealth: The basics of portfolio diversification
WHEN a storm occurs, the best place to be is in a house whose roof, doors and windows are hurricane proof, and better even, a house which is built in an area protected from high winds, storm surges and seismic or earthquake activity.
A diversified investment portfolio is like that safe house in a storm, a home put together in such a way as to reduce total losses when disaster occurs.
Your investment portfolio, which is a collection of assets from various assest classes, should be structured to protect you from the ups and downs of any one event in the financial markets.
Eggs in one basket
Studies have shown that a well-diversified portfolio yields the most cost-effective level of risk reduction, or loss of capital which is the money you placed in the investment.
Financial markets experience upswings and downturns, or volatility from time to time. If you have put all your funds in one investment type, that is similar to putting all your eggs in one basket. When markets move, you are more exposed to potential loss if you invested in one product only.
Protection
The mix is aimed at limiting exposure to any single asset or risk. Each asset chosen behaves differently and is subject to market conditions that vary. To provide an example, you may include in your basket of options stocks which are traded, mutual funds which are based on a mixture of underlying assets, real estate which increases in value over time, and bonds which are debt funding.
Diversification by asset class
Investment managers may present to you a range of options across asset classes. They will assign each a percentage according to your appetite for risk. Some assets are as follows:
• Stocks: These are shares or equity in a publicly traded company.
• Bonds : These are government and corporate fixed-income debt instruments.
• Real estate: Real estate includes land, buildings, natural resources, agriculture, livestock, and water and mineral deposits.
• Exchange-traded funds (ETFs): These are a marketable basket of securities that follow an index, commodity, or sector
• Commodities: These are basic goods necessary for the production of other products or services.
• Cash and short-term cash-equivalents (CCE): These include treasury bills, certificate of deposit (CD), money market vehicles, and other short-term, low-risk investments.
• In Jamaica another option to be considered is Jamaican dollar versus US dollar denominated investments.
Having looked at all the available options, the fund or investment manager may then choose stocks from different industry sectors or stocks with a different market capitalization. Your investment manager may also introduce you to investments in other geographies or countries. The benefit is that foreign securities are unlikely to be subject to the same influences as domestic ones, so they offer a further diversification tool.
Seek professional advice
Spreading your risk is key for long term growth, medium term income or short term principal protection. This may sound difficult for you to balance and determine where to start. We recommend you get guidance and support from experts who can help you to make the right decisions. Sit with an advisor and discuss each asset class and the benefits for your specific circumstances. Diversification hinges on customised portfolio planning which considers each person’s risk appetite, time horizon and personal financial goals. You may book a consultation with a Scotia Investments advisor who can assist you in designing an investment portfolio that will give you the growth you desire.
Sherene Todd is a licensed investment advisor from Scotia Investments Jamaica Limited.
