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ProActiveFinancialPlanning.com |
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The Financial Planning Center Comprehensive Financial Planning
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How to Manage Your Investment Risk |
Diversification vs. Asset Allocation-How to Manage Your Risk?
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Common Investment Mistakes or Poor Investment Decisions?
Diversification vs. Asset Allocation-Managing Investment Risk Hope for the Best but Plan for the Worst Summary |
Blind Diversification vs. Strategic Diversification When investors diversify their portfolio, they are attempting to
reduce risk (variance) by offsetting losses from one investment with
gains from another. However,
when it comes to selecting the proper securities based on the
interrelationship of their returns, most investors go awry.
Is diversification really being accomplished if the security
being added reacts similarly to other securities in the portfolio?
If you have two or three mutual funds that invest in similar
asset classes, you haven’t diversified.
You have not reduced the nonsystematic risk portion of your
portfolio effectively. The
funds you have will tend to move together without offsetting any
losses. The proper way to strategically diversify your portfolio would be
to add a security that behaves inversely to your current holdings. By adding a security with an inverse relationship, you have a
better chance of offsetting losses from other assets. This is how nonsystematic risk is reduced.
By adding securities that do not move in a similar fashion, you
will reduce volatility of your portfolio.
How do you know which security to add?
The proper way to add an asset class that will reduce nonsystematic
risk is to run a regression analysis to determine the correlation
coefficient. Correlation
in our example can be defined as how the returns of a security vary
with respect to other security returns.
Having an accurate assessment of the behavior between the past
returns from different asset classes will allow you to optimize your
objective - to reduce nonsystematic risk in your portfolio. In conclusion, a portfolio with a correlation coefficient of less than one should reduce nonsystematic risk more effectively than a portfolio with a higher correlation coefficient. When adding an asset that reduces your correlation coefficient, you have essentially reduced the risk of your portfolio even if it is a riskier asset that will increase the overall return of the portfolio. This module is available by email in a seven-page, printable version upon request Contact ProActive Financial Planning to Request.. |
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