Diversifying Your Forex Portfolio For Long-term Profitability In Canada – Diversification is a risk management strategy that creates a mix of different investments within a portfolio. A diversified portfolio includes a combination of different asset types and investment instruments that aim to limit exposure to a single asset or risk.
The rationale behind this technique is that a portfolio consisting of different types of assets produces, on average, a higher long-term return and reduces the risk of an individual holding or security.
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Research and mathematical models have shown that maintaining a well-diversified portfolio of 25-30 stocks produces the most cost-effective level of risk reduction. Investing in more securities gives you more diversification benefits, but it makes it less effective.
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Diversification aims to smooth out unsystematic risk events in the portfolio, so the positive return of some investments neutralizes the negative return of others. The benefits of diversification only apply if the securities in the portfolio are not perfectly correlated – that is, they react differently, often in opposite ways, to market influences.
When investors consider ways to diversify their holdings, there are dozens of strategies to implement. Many of the methods below can be combined to increase diversification within a single portfolio.
Fund managers and investors often diversify their investments between different asset classes and decide what percentage of the portfolio to allocate to each. Each asset class has different, unique risks and opportunities. Categories may include:
According to the theory, what may negatively affect one asset class may benefit another. For example, a rise in interest rates usually has a negative effect on bond prices, as yields must rise to make fixed income securities more attractive. On the other hand, an increase in interest rates can lead to an increase in real estate rent or an increase in commodity prices.
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There are huge differences in the operating methods of different industries or sectors. When investors diversify into different industries, sector-specific risks weaken for them.
Consider, for example, the CHIPS and Science Act of 2022. This legislation affects many industries, although some companies are affected more than others. Semiconductor manufacturers are largely affected, while the financial services sector may feel smaller residual effects.
Investors can diversify different industries by combining investments that can balance different businesses. For example, consider the two main modes of entertainment: travel and digital streaming. Investors looking to hedge against future major pandemic impacts can invest in digital streaming platforms (which are positively impacted by more shutdowns). At the same time, they can consider investing in airlines at the same time (smaller downtimes have a positive effect on this). In theory, these two independent industries can minimize the overall risk of the portfolio.
Stated that there are simply too many variables to consider, and “there is no optimal number of stocks that make up a well-diversified portfolio.”
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Public stocks are generally divided into two categories: growth stocks and value stocks. Growth shares are shares in companies whose income or turnover is expected to grow faster than the industry average. Value stocks are stocks in companies that appear to be trading at a discount based on the company’s current fundamentals.
Growth stocks are usually riskier because the company’s expected growth may not materialize. For example, if the Federal Reserve tightens monetary policy, capital is generally less available (or more expensive to borrow), creating a more difficult scenario for growth companies. However, growth companies can take advantage of seemingly limitless potential and exceed expectations, generating even higher returns than expected.
On the other hand, value stocks tend to be more established, stable companies. Although these companies have already experienced most of their opportunities, they tend to have less risk. By diversifying into both, an investor could take advantage of the future potential of some companies while recognizing the existing advantages of others.
Investors may want to consider investing in different securities based on the underlying market value of the asset or company. Consider the vast operational differences between Apple and Newell Brands Inc. As of July 2023, both companies were in the S&P 500, with Apple represented by 7.6% of the index and Newell Brands by 0.0065%.
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Each company has a significantly different approach to raising capital, bringing new products to market, brand recognition and growth potential. Smaller stocks have more room to grow, although larger stocks tend to be safer investments.
In almost all asset classes, investors can choose the underlying risk profile of the security. For example, consider fixed income securities. An investor can buy bonds from the world’s top governments or nearly defunct private companies that are hoarding emergency funds. There are considerable differences between several 10-year bonds based on the issuer, their credit rating, future operating prospects and current debt levels.
The same can be said about other types of investments. Riskier real estate development projects can bring with them a bigger rise than established operating real estate. At the same time, cryptocurrencies with a longer history and wider adoption, such as Bitcoin, carry less risk compared to smaller market capitalization coins or tokens.
Diversification may not be the best strategy for investors looking to maximize their returns. Consider YOLO (you only live once) strategies, where 100% of the capital is invested in a high-risk investment. While the probability of making life-changing money is higher, the probability of losing it due to poor diversification is also higher.
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For fixed-income securities such as bonds, different maturities affect risk profiles. In general, the longer the maturity, the greater the risk of bond price fluctuations due to interest rate changes. Short-term bonds generally offer lower interest rates; However, they are also less affected by the uncertainty of future yield curves. Risk-averse investors may consider adding longer-term bonds, which typically pay higher interest rates.
The maturity length is also prevalent in other asset classes. Consider the difference between short-term leases for residential properties (ie, up to one year) and long-term leases (ie, sometimes five years or more) for commercial properties. Although it is safe to collect rental income by committing to a long-term contract, investors sacrifice flexibility to raise prices or change tenants.
Investors can get more diversification benefits by investing in foreign securities. For example, the forces weighing on the US economy may not affect the Japanese economy in the same way. Therefore, owning Japanese stocks gives an investor some protection against losses during a downturn in the US economy.
Alternatively, there may be greater potential upside (with greater risk) when diversifying between developed and developing countries. Consider Pakistan’s current classification as a frontier market player (recently downgraded from an emerging market player). Investors who are willing to take on higher risk may want to consider the higher growth potential of smaller, not-yet-fully-established markets such as Pakistan.
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Financial instruments such as stocks and bonds are intangible investments; they cannot be physically touched or felt. On the other hand, tangible investments such as land, real estate, farmland, precious metals or commodities can be touched and have real applications. These properties have different investment profiles because they can be consumed, rented, developed or processed differently than intangible or digital assets.
Tangible assets also come with unique risks. The property can be vandalized, stolen, damaged due to natural conditions or become obsolete. Fixed assets may also require storage, insurance or security costs. Although the income stream differs from financial instruments, the input costs associated with the protection of tangible assets are also different.
Regardless of how an investor considers constructing their portfolio, another aspect of diversification relates to how these assets are held. Although this is not related to the risk of the investment, it is an additional risk worth considering because it can be diversifiable.
For example, consider a person who has $400,000 in US currency. In all three situations below, the investor has the same asset allocation. However, their risk profile is different:
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The same concept above applies to almost all asset classes. For example, Celsius Network filed for bankruptcy in July 2022. Investors who held cryptocurrencies on the exchange experienced the inability to withdraw or transfer funds. If the investors had spread over different platforms, the risk of loss would have been spread over different exchanges.
Consider different strategies to offset technology risk and physical risk. For example, owning physical gold bars and gold ETFs diversifies your portfolio with different risks. If your physical holdings are stolen, at least 100% of your gold holdings are not lost.
Time and budget constraints can make it difficult for non-institutional investors, i.e. individuals, to create a sufficiently diversified portfolio. This challenge is the key to why mutual funds are so popular with retail investors. Buying mutual fund shares offers an affordable way to diversify investments.
While mutual funds offer diversification across asset classes, exchange-traded funds (ETFs) offer investors access to niche markets such as commodities and international plays that would normally be difficult to access. A person with a $100,000 portfolio can split the investment among ETFs without overlap.
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There are several reasons why this is advantageous for investors. First, it can be too expensive for retail investors to buy securities from different markets
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