Diversification of Investment Portfolio

 by Saltiel Shino

Diversification of investment portfolio. [source/ insight success]

It's no secret that 2022 was a difficult year for financial markets.

The combined effects of the Russia-Ukraine war and China's hard Covid-19 lockdowns, coupled with global supply chain constraints, drove global inflation to astronomical levels in major economies in 2022.

The United States (US), for example, reached a 40-year high of 8.6 per cent in May, peaking at 9.1 per cent in June this year.

This prompted central banks around the globe to implement aggressive interest rate hikes as a fight against blistering inflation and currency weaknesses.

Financial markets tumbled worldwide as hot inflation and surging interest rates heightened fears of a global recession.

The Standard and Poor's 500 (S&P 500) plunged by 20.58 per cent in the first half of the year, while the Johannesburg Stock Exchange (JSE) All Share Index dropped 10.16 per cent and the Namibian Stock Exchange (NSX) Local Index was 6.9 per cent lower.

Markets started showing signs of recovery in October 2022 as the narrative of global slowing in the pace of interest rate hikes inspired some positive equity performance.

By the end of November 2022, equity markets recovered some of the losses suffered in the first half of the year, but remained in a depressed state.

The S&P 500 was down 14.39 per cent, while the JSE All Share crawled back into positive territory, recording a return of 1.52 per cent year to date, and the NSX Local Index was 4.65 per cent down for the same period.

Therefore there is not much to cheer about in 2022 for the investor who is already under pressure of diminishing purchasing power due to rising inflation and high interest rates.

As the year comes to an end, many investors may be wondering how to better position their investment portfolios for the new year given the significant volatility experienced in 2022.

The goal of every investor is to maximise return while minimising the risk of loss.

However, 2022 provided us with a fresh reminder that uncertainty and volatility are features inherent in all capital markets, which makes it difficult to predict which asset class would perform best in a given period.

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Therefore investors are faced with the daunting task of finding investments that meet their investment goals.

Although there is no simple formula for achieving every individual or institutional investor's investment goals, several studies have established that the most important decision in creating wealth is deciding upon asset allocation.

This is the process of deciding how to distribute an investor's wealth among different countries and asset classes for investment purposes.

An asset class is composed of securities with similar characteristics, attributes, and risk/return relationships.

Traditionally, the main asset classes are equity investments (dividend-earning investments), bonds (interest-earning investments), property (rent-earning investments), and cash.

For example, a hypothetical investor with N$100 000 can decide to construct a portfolio based on an asset allocation of 60 per cent equity, 30 per cent bonds and 10 per cent in money market instruments.

The rationale is that diversifying across asset classes should yield better trade-offs between risk and return than investing solely in one single security or asset class.

This is because assets perform differently in different periods, and it is difficult to predict which asset will perform best in a given period.

One of the key pillars of asset allocation is diversification. Diversification is a technique that reduces portfolio risk by allocating investments across various asset classes, geographies, industries, and other categories.

The underlying principle of diversification rests on the notion that different asset classes and industries offer returns that are not perfectly correlated, hence diversification reduces the overall risk in terms of variability of returns for a given level of expected return.

While asset allocation gives an overarching plan and strategy that defines what portion of your portfolio to invest in different asset classes, diversification involves distributing the investor's wealth across asset classes, sectors, and currencies.

For example, based on the hypothetical investor described above, if that 60 per cent equity allocation is invested solely in one blue-chip mining company on the JSE without broad exposure to other sectors (financials) or regions (foreign equity), then it lacks diversification and hence could be a high-risk strategy.

In the event that the share price of the mining company collapses, the investor will see 60 per cent of his portfolio wiped out overnight.

Therefore diversifying across different asset classes and sectors mitigates this risk, because when some assets, industries or companies are falling in value, others tend to rise – thus offsetting those losses on average across all investments.

Although asset allocation and diversification do not guarantee superior returns, a properly allocated and well-diversified portfolio is more likely to meet the investor's return objectives in different economic circumstances while reducing overall market risk over the long term.

In this respect diversification has been described as “the only free lunch you will get in the investment game”.

Read original article here: The Namibian