At the time of writing, the Straits Times Index (SGX: ^STI) – at 3,525 points – has gained 18% over the last 12 months, and is near a 52-week high. At these conditions, many investors may be getting increasingly worried about a correction being just around the corner.
So, I thought it will be interesting and useful to discuss one simple and efficient method that investors could use to possibly protect their portfolio. This method is known as diversification.
Diversification is basically spreading your money across a wide range of investments. Doing so can help to remove an over-reliance on the performance of a handful of assets to drive your portfolio’s returns; it also protects your portfolio should one or two investments turn sour. Moreover, in a diversified portfolio, you increase your chances of having some investments that thrive while the market or economy isn’t doing well.
So what diversification options are available to investors? Here are a few.
Diversify amongst asset classes
Asset classes refer to stocks, bonds, real estate, and cash. Stocks have historically been shown to be volatile. But by holding a portion of your portfolio in bonds, you could experience dramatically lower volatility.
Here’s a blog post by investor Ben Carlson showing that a 50/50 portfolio (a portfolio made up of 50% in stocks and 50% in bonds) had been way less volatile than owning just stocks over a long period of time.
Diversify within an asset class
It’s important to also diversify within an asset class. For instance, let’s say your portfolio is 50% in stocks, and 50% in bonds. That looks diversified on the surface.
But what if your stock-portion consists of just shares in one company, and your bond-portion consists of bonds from the same company? In this instance, the fate of your portfolio is solely dependent on just one company. If this company were to go bust, you would lose everything. It’s important to diversify within an asset class too. And this means holding a basket of different stocks, and different bonds.
Lastly, investors can also diversify across different geographical markets. Instead of buying stocks in just one country, you could buy stocks in different countries. Markets around the world don’t move in tandem.
A great example can be found in data produced by Carlson in another blog post. From 1994 to 1998, the MSCI Emerging Market Index declined by 38.5% while the S&P 500 in the US gained 191.3%; but from 1999 to 2007, the MSCI Emerging Market index produced an outstanding return of 420.1% while the S&P 500 returned only a paltry 37.5%.
In sum, due to the inherent uncertainties in the markets, it is essential that investors diversify.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.