A Balancing Act

A Balancing Act
Diversifying one’s portfolio is a common practice for any savvy investor. But what happens when you over-diversify and what can you do to get back on track?
Whether you are a new or savvy investor, diversification is likely not a term that is new to you.
Investors have always been advised not to put all their eggs into one basket to limit losses and to mitigate against the vagaries of the market without sacrificing too much potential gain in order to meet their financial goals.
Diversification basically involves spreading your money amongst various investments in the hope that if one investment loses money, other investments will make up for those losses.
Strategic Planning
Many investors use asset allocation as a way to diversify their investments among asset categories.
Fund managers say one’s portfolio can be diversified at two levels: between asset categories and within asset categories. Apart from allocating your investments among different asset classes such as stocks, bonds and other categories, you will also need to spread out your investments within each asset category.
The key is to identify types of investment that may perform differently under different market conditions.
For example, it is a general rule of thumb that bonds and stocks are two asset classes that move in opposite directions in an economic cycle. Therefore having a toehold in both will likely ensure you spread out your investment risks in a particular period in that cycle.
Additionally, a way to diversify your investments within an asset class is to invest in a wide range of companies and sectors. Note that the stock portion in your portfolio won’t be diversified, for example, if you only invest in four or five individual stocks in a similar industry. You’ll need to invest in at least a dozen stocks in different industries to be truly diversified.
Not Fail-Safe But Prudent
Most investment professionals agree that although diversification is no guarantee against loss, it is a prudent strategy to adopt towards your long-range financial objectives.
Because achieving diversification is challenging, some find it easier to just invest in mutual funds that offer some form of diversification although you will need to pick your mutual funds wisely given the variety of funds available in the market.
But more importantly, establish an asset allocation strategy that works for you because there is no such thing as the perfect portfolio. Draw up a strategy that fits into your target investment returns within your time horizon.
Overdoing It
Note that it is very possible to overdo your diversification strategy.
After a certain point, adding more funds to your portfolio just creates additional bookkeeping and tax headaches, while doing little or nothing to increase returns or lower risks.
But how much diversification is too much? It is not easy to say when one has over diversified because everyone has a different risk appetite.
But simply put, when you begin to find it difficult to monitor your portfolio of investments, quite likely, you have bitten off more than you can chew.
It is important to be able to keep up with the development of the assets that you have invested in and this goes beyond just keeping tab on the price movement of your investments. You need to also monitor the fundamentals and keep an ear out for any buzz surrounding those assets that you’ve invested in.
So while it may seem like a good idea to dabble in every possible segment of asset class to spread out your risk, note that overdoing it makes diversification meaningless after a while.
Rebalancing Your Portfolio
When you’ve over diversified or find that the weighting of each asset class in your portfolio has changed over time, it is a good time to realign your portfolio. This is known as rebalancing your portfolio.
Rebalancing is bringing your portfolio back to your original asset allocation mix. This is necessary because over time, some of your investments may meander out of alignment with your investment goals. By rebalancing, you'll ensure that your portfolio does not overemphasize one or more asset categories and you'll return your portfolio to a comfortable level of risk.
Just as you diversified between asset categories and within asset categories, you'll also need to review your investments within each asset allocation category when you rebalance your portfolio.
There are basically three different ways you can rebalance your portfolio:
1.
Sell off investments from over-weighted asset categories and use the proceeds to purchase investments for under-weighted asset categories
2.
Purchase new investments for under-weighted asset categories
3.
If you are making continuous contributions to the portfolio, you can alter your contributions so that more investments go to under-weighted asset categories until your portfolio is back in balance.
Investors are advised to rebalance their portfolios at regular intervals such as every six or twelve months.
Before you rebalance your portfolio, you should consider whether the method of rebalancing you decide to use will trigger transaction fees or tax consequences.
Understand exactly what is in your investment portfolio and why you own it is an integral part of the diversification process. At the end of the day, it is about how well you know the investments that you are putting your money into and whether you are comfortable with the risk you are taking to reach your goals within the chosen timeframe.
And once you’ve come up with a game plan, stick to the game plan to reap the results over the long term.
Source: Calibre, July 20