The role of diversification in uncertain times

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Understand the benefits of implementing a diversification strategy when investing.

In times of market uncertainty and volatility, investors need to pivot investment strategies in order to lower investment risks. Diversification may be the best defensive play for investors considering current market concerns such as the effect of the COVID-19 pandemic,[1] pandemic lockdown restrictions in China – one of the world’s largest economies – which in turn hampers global supply chains,[2] and the ongoing conflict between Russia and the Ukraine.[3]

Diversification is a balanced approach

Diversification is important to investors as it is a way of harmonising the risk/reward ratio and capitalising on beneficial investor opportunities. Allocating capital into a variety of assets lowers risk exposure when it’s based on an investor’s personal comfort level with risk. According to Warren Buffett, “A policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.”[4]

However, Ray Dalio believes the main reason for promoting diversification is to avoid bias.[5] When an investor holds a specific view of the market and potential investments, this can cause a lost opportunity. While it may be hard to let go of bias, the trick is to continually reassess how you are investing. Implementing a diversified investor style will reduce bias and therefore capitalise on investor opportunities while balancing risk with reward.

The world is changing and with that, we must transform our conditional way of thinking. It’s no longer about buying one real estate property or trusting in a sole financial advisor; it’s about diversification and investing in the most advantageous investments and global opportunities. Rather than concentrating money on a single business, industry or asset class, investors can follow a balanced approach to diversifying their investments across a range of different companies, industries, and asset allocations.[6]

“The phrase ‘don’t put all your eggs in one basket’ is another way of saying that no one should risk all their resources on any single idea, venture, or asset.” [7]

Understanding the relationship between risk and returns by diversifying investments

Ray Dalio manages around $154 billion (USD) in Bridgewater Associates and has an estimated personal net worth of $22 billion (USD).[8]  He founded Bridgewater and Associates in 1975 from his two-bedroom apartment in New York City and grew it into one of the world’s largest hedge funds.[9] By following his investment advice on diversification, investors can also achieve success with their asset portfolios.

As a respected financial expert, he has this advice for investors to maximise risk resiliency without lowering expected returns. “Diversify between currencies, asset classes, and countries as the best way to reduce risk without reducing opportunity.”[10]

An investor should consider diversifying an investment portfolio based on the following:

  1. Different asset allocations – ensure there is a mix of different asset classes, from cash to stocks, bonds and exchange-traded funds, and so forth. Diverse asset types carry dissimilar levels of risk and may equalise the overall risks and returns.
  2. Risk levels – interest rates affect the profitability of specific assets; the value of a fixed-income investment will decrease when interest rates increase. Another factor for consideration is the market risk, as the systemic risk from the stock market must be considered when investing in non-cash assets.[11]
  3. Asset allocation geographies – the locations of investment assets are influenced by social or political factors as well as the financial markets. Investing in diverse global assets lowers the risk that all the investments are affected when uncertainties in the market come into play, for instance, when stock market crashes occur.[12]
  4. Local and international markets – investing in both domestic and foreign markets counters risks and increases the odds of profitable returns when one market isn’t performing well.

In summary, to obtain a higher resilience to risk, an investor’s investment portfolio must have diverse global assets.[13]

Adopt a successful diversification investment strategy

He goes on further to explain this strategy in detail and calls this the holy grail of investing. Dalio advises that investors, “need 15 uncorrelated bets, an array of attractive assets that don’t move in tandem, reduce risk by 80% and risk/return ratio increases by a factor of 5!”[14]
While the above quote from Dalio might not make sense at first, simply put, if investors channel their wealth into 15 diversified investments – if these are completely different investment assets from stocks to real estate or cryptocurrency – this will in turn lower the total risks to the investor. This then improves the odds that the majority of the 15 investments will provide profitable returns. In fact, this lowered risk seems to improve returns exponentially by five times.

Here’s an investment example:

Imagine if an investor did this, take $100,000 (USD) and invest $10,000 (USD) in 10 alternative asset investment opportunities. This means these investment assets are diversified across countries, currencies and assets.

If two of the assets don’t perform well, the other 80% are still working. Therefore, the risk is reduced by 80%, and there is no correlation between these assets and no movement in tandem. The income and capital growth are diversified across 10 opportunities, and the risk or return ratio is increased by a factor of five. 

Harness a diversification investor strategy

Wealth Migrate’s FinTech platform, has 30,000 members from more than 170 countries in their global and diverse meta-marketplace. They’ve made it possible for investors to access institutional-grade real estate and alternative asset deals, from leading suppliers to locations worldwide.

As part of an ongoing educational series, discover what Wealth Migrate’s perspective is on Diversification 5.0 and how the wealth pyramid can be used as a formula to diversify an investor’s portfolio in their next article.

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[1] Amstad, M., Cornelli, G., Gambacorta, L., and Xia, D. (June 2020). ‘BIS Bulletin 25. Investors’ risk attitudes in the pandemic and the stock market: new evidence based on internet searches’. Retrieved from BIS.

[2] Yen Nee, L. (August 2021). ‘China’s Covid lockdown could have economic costs to the world, says strategist’. Retrieved from CNBC.

[3] J. P. Morgan. (March 2022). ‘The Russia-Ukraine crisis: what does it mean for markets?’. Retrieved from J. P. Morgan.

[4] Duggan, P. (April 2020). ‘Why asset class diversification is critical for investors’. Retrieved from Investec.

[5]  Brock, C. (June 2022). ‘Ray Dalio’s investment strategy’. Retrieved from The Motley Fool.

[6]

Robbins, T. (February 2017). ‘Unshakeable: your financial freedom playbook creating peace of mind in a world of volatility’. Retrieved from Unshakeable.

[7] Dong, T. (May 2022). ‘Why diversification is important in investing’. Retrieved from U.S. News.

[8] Forbes. (June 2022). ‘Ray Dalio’. Retrieved from Forbes.

[9] Forbes. (June 2022). ‘Ray Dalio’. Retrieved from Forbes.

[10] Graffeo, E. (November 2020). ‘Investing legend Ray Dalio tells investors to not own bonds or cash’. Retrieved from Markets Insider.

[11] Duggan, P. (April 2020). ‘Why asset class diversification is critical for investors’. Retrieved from Investec.

[12] Duggan, P. (April 2020). ‘Why asset class diversification is critical for investors’. Retrieved from Investec.

[13] Dong, T. (May 2022). ‘Why diversification is important in investing’. Retrieved from U.S. News.

[14] Robbins, T. (February 2017). ‘Unshakeable: your financial freedom playbook creating peace of mind in a world of volatility. Retrieved from Unshakeable.

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