[In layman’s term] Diversify to build an all-weather portfolio

🌰In a nutshell: while it is impossible to completely avoid all risks, you can minimize losses by having a diversified portfolio. Diversification means having your portfolio comprised of multiple asset classes that react differently to a given event. When one asset zigs, the other zags, and the combination of the two helps you stay on track to meet your goal.

There’s a story of a mother whose two sons were both merchants. One was selling umbrellas, and the other was selling hats. When it was sunny, she was concerned about her son selling umbrellas. When it rained, she was worried about the other son who was selling hats.

The moral of the story is to encourage people to change their perspective. Instead of looking at the negative, try focusing on the positive: happy about the umbrella seller when it rains, instead of sad about the hat seller.

We suggest the third option. How about having both umbrellas and hats??? Prepared for both kinds of weather?

That concept is applicable even in the investment arena. We call it diversification

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What is diversification?

Diversification in the core is the notion of spreading your money across a range of investments. It reduces risks and protects against unexpected dropdowns in any particular market, sector, or individual investment. When your portfolio is diversified, returns from better-performing assets can help offset those that underperform.

Let’s talk about diversification in conjunction with the COVID-19. The World Health Organization (WHO) declared COVID-19 as a pandemic, and it has led to some visible effects on businesses. First, numerous flights were canceled and many travel agencies were forced to postpone their trips. As the general atmosphere discourages people from having big events, event planning industries are suffering from canceled events. However, there are companies that are doing much better as well, they are those in the delivery business, and mask, health products, or even nutritional supplements. If your assets were to be over-committed in the flight industry, your overall portfolio would have suffered greatly under these circumstances. However, if you had your money spread in all these industries, your portfolio might have gained in value.

The following demonstrates value fluctuation in assets over time. While the numbers are arbitrarily assigned, the idea still stands. Asset performances change over the year. Given the overall market is on the rise, it is best to have your money spread over different kinds so that you can gain returns no matter which asset performs the best or the worst.

periodic table for asset diversification

The two concepts you want to consider when planning diversification are the following

  1. Risk tolerance: how well can -or can’t -you cope with potential losses. If you have a higher tolerance, then you could consider allocating a greater proportion of your money to assets with higher risk for potentially higher return.
  2. Time horizon: how much time do you have until you need your capital. Do you need your capital liquidated in a year, or do you have more than 5 years until you need your money?
Mix your portfolio to include assets of all risk/profit levels
Data source: Nasdaq.com

In order to really have your portfolio well-diversified, you would need good understanding of where the risks may lie.

Understand sources of risk

While the risks may arise from various circumstances, we would like to highlight some common sources of uncertainty and volatility.

Interest rates: For instance, if the Federal Reserve lowers the interest rates, the cost of borrowing decreases. This will cause the demand for loans to increase. As such, bond prices may rise, stock prices may rise, saving accounts and CDs will have lower rates, commodity price rises, and mortgage rates fall.

effect of low interest rates

Corporate earnings: this relates closely to the rise and fall of stock prices. As such, corporate earnings often are used as a metric to gauge the stock price of the company. There is a financial metric for this, called price per earnings ratio, or P/E.

Policy: Government policies on matters such as trade, legalization of cryptocurrency trade, and international relations can greatly affect the level of uncertainty.

On March 5, South Korea’s National Assembly passed a revised bill that has a significant impact on the crypto industry. To be Implemented in March 2021, the revised bill is expected to allow the crypto business to start accepting fiat. This will change the game for crypto companies based in Korea.

 

 


Understand the types of risk

While we just looked at the common sources of risk, let’s also take a look at types of risk that may also affect your portfolio performance.

Country risk: the domestic events that can negatively affect the market. Examples could be political instability, financial crisis, or so on. You may want to invest in foreign markets to diversify the risks.

Currency risk: the possibility of currency exchange rates can cause a drop in value.

Inflation risk: High inflation causes value depreciation especially when the interest rate is low. Not only can it erode the value, but it can also weaken your purchasing power.

Liquidity risk: It is associated with the chance of buying and selling your assets. Higher the risk, more difficult it would be for you to liquidate your assets.

Market risk: When the risk is associated with the majority of asset classes, it is classified as the market risk. This risk is the risk that your investment return across the market may fluctuate.

Shortfall risk: This will be a culmination of diverse factors as it represents your portfolio may not meet your long-term investment goal.

As you see, there are a lot of factors contributing to risk. As risks, by their nature, are often unpredictable, you are comprising your portfolio in such a way that it can endure all scenarios. In order to have your portfolio stay strong and healthy even in the changing market situation, you need to do the next step: rebalancing.

The main purpose of rebalancing is to re-calibrate the risk level of your portfolio so that it can remain within the tolerance level you initially set even in the changing market.

We will talk about the rebalancing and asset allocation in the next post.

Until then, why don’t you try our free crypto portfolio analyzer to assess your risk level and compare it against the benchmark assets?

Yes, it is free.

Want to review the performance of your crypto portfolio using proven metrics from the traditional financial industry for free?

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References
“Diversification In Investing May Reduce Risk | U.S. Bank”. Usbank.Com, 2020, https://www.usbank.com/investing-and-retirement-planning/financial-perspectives/diversification-important-in-investing-because.html

Pettinger, Tejvan. “Effect Of Lower Interest Rates – Economics Help”. Economics Help, 2020, https://www.economicshelp.org/blog/3417/interest-rates/effect-of-lower-interest-rates/.

“Understanding Your Risk Tolerance And Time Horizon”. Nasdaq.Com, 2020, https://www.nasdaq.com/education/understanding-risk-tolerance-time-horizon.

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