Market Beat: Portfolio diversification – spreading your risk
TRUCKEE, Calif. – Modern portfolio theory plays an important role in financial planning today. The theory was originally pioneered by Harry Markowitz who won a Nobel Prize for his work.The results of Markowitz’s research suggest that investors can get a better rate of return from their portfolios and have less risk if they diversify across assets whose returns have a low correlation to one another. In other words, investors should try to have a portfolio where all of the investments don’t always move in the same direction. They should try to be diversified enough so that if one portion of the portfolio is declining in value another may be appreciating in value at the same time.Just a few years ago, aggressive equity investors could find some diversification by including foreign stocks in their mix. An analysis today will show that the world’s major stock indexes have become highly correlated which means that they will generally move in the same direction at the same time.Typically, bonds will have a negative correlation to stocks which is what makes a portfolio of half bonds and half stocks more conservative than an all stock portfolio. A typical all stock portfolio of 20-30 stocks, even if they are in different industries, could in fact be highly correlated, they could all move pretty much in the same direction the majority of the time.Investors who want to lower risk through asset allocation and diversification need to consistently analyze their holdings for correlation and be prepared to make adjustments. Asset correlations can change over time, and a portfolio that was highly diversified a few years ago may have become highly correlated over time.Today, the rapid growth of exchange traded funds has made it easier than ever before to add alternate asset classes to a portfolio. Commodities like metals and energy products and currencies can help to diversify portfolios away from just the traditional all stock or stock and bond mix portfolio.It’s important to pay attention not only to the fundamentals of the asset class you’re considering, but how that asset correlates to your current holdings. In other words you have to consider whether adding another investment make your portfolio more diversified or if you’re adding something that will behave like the rest of your holdings.Kenneth Roberts, a Truckee-based Registered Investment Advisor, has been in the securities business since 1992, has worked as a branch manager for a major Wall Street firm and is currently a portfolio manager for Fusion Asset Management. Information on his money management service can be found at http://www.fusiontargetretirement.com or by calling 775-675-8065. Past performance does not guarantee future results. Consult your financial adviser before purchasing any security.
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