AMFIE ACADEMY Building a diversified portfolio

Diversification is an important means of reducing risk and volatility in an investment portfolio, however few people diversify properly. Instead of simply searching for individual investments, we suggest that you take a broader view and focus on designing your portfolio in a structured manner.

From the beginning, your investment strategy will determine the structure of your portfolio, which will, in turn, form the basis for ensuring
portfolio diversification. This is because the structure of your portfolio defines, in accordance with your risk and return objectives, the allocation between growth assets and defensive assets, as well as the choice of investment vehicles.

Choosing a mixture of different asset classes that historically have not moved in the same direction provides a first level of  diversification. Investors often seek a mix of equity investments and fixed-income investments, such as bonds. However, other asset classes including commodities, real estate and foreign currency exchange have different characteristics and can therefore also
provide diversification. For example, commodities have historically been negatively correlated with equities. In other words, if equities are underperforming, commodities are likely to be generating higher returns, thus potentially offsetting part of the impact of the poorly performing asset class on the overall portfolio.

Once you have decided on a range of asset classes, it is necessary to extend this diversification by ensuring that your portfolio has broad international exposure, as well as exposure to different sectors, market segments, and categories of instruments. This will provide a second level of diversification. The third level of diversification involves building a portfolio composed of a large number of securities
with different characteristics and that behave in different ways. Investing in a substantial number of securities within each asset class and region will contribute to lowering the risk associated with each individual security and will improve the portfolio’s risk return ratio.

The benefits of portfolio diversification are only apparent over the medium and long term because the performance of most asset classes is inconsistent over the short term. Therefore, it is important to invest over a sufficiently long-term period.

 

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