Investment guide for 2009: diversification

Last week we started the discourse on the forces of risk and return as the two major factors every investor who intends to succeed in the investment world in 2009 must come to terms with. I had explained the weaknesses and strength in the different classes of assets. This week we will be looking at how to create a balanced investment portfolio through good diversification.

You’re almost certainly familiar with diversification, but it is also one of the most misunderstood investment concepts.

Diversification is one of the most commonly discussed topics among all types of investors-from those just starting out to the largest money managers on Wall Street. The reason: “Diversification is, without question, one of the keys to your success as an investor, “But you must employ it correctly”

As an investor, it’s crucial to ask yourself two important questions about your portfolio: Am I truly diversified? And am I taking advantage of all the strategies at my disposal to capture the full range of diversification benefits?

True diversification

The basic idea behind diversification is simple: Don’t put all your eggs in one basket. That said, simply owning a large number of stocks or other investment doesn’t automatically make you diversified. The key, is to spread your capital across a wide variety of asset classes and asset styles that have fundamentally different risk and return characteristics.

Such investments typically behave differently from each other during a market cycle-bonds often perform well during periods of stock market weakness, for example, while some international shares might rally when the Nigerian market falls.

By combining different types of asset classes, you can enhance your portfolio’s return potential, while simultaneously lowering its overall level of risk.

These advantages can be especially important for investors looking to preserve what they’ve earned. For example, consider an executive whose wealth is concentrated in his or her company’s stock. “The same stock that makes an investor wealthy can also damage that wealth if it runs into trouble, as within the past six months with many companies and CEO’s” If one of your goals is to preserve your capital, diversification is an absolute must. Feelers reaching us have shown that the world’s richest men are not immune to the mess caused by the financial crisis because of poor diversification. It was recently carried in a national daily that virgin Nigeria might be running into cash flow troubles; this is a company that Richard Branson would have easily assisted in times past if the cash was there.

Diversification is a useful technique that can reduce overall portfolio risk and volatility. Diversification neither ensures against a profit nor protects against a loss. Each investment type has different investment and risk characteristics. Bonds, treasury bills, treasury certificates and other money market instruments have fixed principal value and yield if held to maturity. Bonds have market risk, interest rate risk and credit risk. Stocks can have fluctuating principal and returns based on changing market conditions. The prices of small company stocks or penny stocks generally are more volatile than those of large company stocks this is evidenced by the significant losses witnessed in the insurance sector of the Nigerian stock exchange in 2008.

Asset allocation

One of the most effective ways to diversify an investment is with asset or fund allocation, and it is a good way to help smooth out volatility in your portfolio.

How does asset allocation work? Different asset classes (such as stocks, bonds, properties) may respond differently to the same market conditions. This means if one part of a diversified portfolio does poorly it can be buffered by other investments that do relatively better. In other words, asset allocation helps spread the risk over several investments. The key to asset allocation is investing in assets with dissimilar performance. While the scientific and measurable investing principles of asset allocation are sound and are well proven, up until recently the process required some detailed mathematical calculations.

A properly diversified portfolio within the Nigerian economic terrain should include investments in a variety of industries and asset classes such as cash, stocks, government bonds, fixed annuities, insurance policies, real estate, and personal business endeavours. A Detail study of these different classes of diversification for a Nigerian investor will form the focal point of our discussion in the next edition.