By: Jeff Deloglos, Trust Officer, ESSA Bank & Trust
It’s been a rough winter. A series of Nor’easters brought high winds, tree damage, and downed power lines. A loss of electricity means no heat either, right? Well, not exactly. We now have diversified sources of heat. People have added propane fireplaces, wood stoves, and gas generators to power space heaters. Diversification has made the end goal of “heat” possible from a variety of mutual sources. Those who had a variety of heat sources avoided feeling cold and uncomfortable; much like diversification in markets can help avoid feeling uncomfortable about your investment portfolio.
What is investment diversification and how is it associated with risk management and portfolio design? A broad definition starts with diversification as a risk management technique used to build a portfolio, which is comprised of a wide variety of investments. These investments come from many sectors and include stocks, bonds, mutual funds, cash equivalents, and exchange-traded funds (ETFs). Diversification strives to smooth out events, allowing the positive performance of some investments to neutralize the negative performance of others. A diversified portfolio should also be balanced between asset categories since segments of each category may perform differently under the same market conditions. Components of diversification include identifying a proper asset allocation, risk level, and expected returns.
Asset allocation is often defined as an investment strategy which balances risk and reward by apportioning a portfolio’s assets according to an individual’s goals and risk tolerance, given the investment time horizon. Objectives are balanced by using ratios, which pertain to the underlying classification of holdings. Many asset allocation models suggest the inclusion of global diversification, especially as more international economies become stabilized and qualify to participate. As a risk offset, bad news for domestic markets may be good news abroad. Investors may be positioned to capture returns based on overall participation in multiple markets.
When considering investment risk, we are faced with the probability of experiencing losses relative to expected returns. The reward for taking on risk is the potential for greater gains. The level of uncertainty one faces in achieving the returns provides an opportunity to evaluate time frames. Diversification enters the picture when we consider the financial goals with long vs. short term durations. A longer term would be required for a more heavily weighted equity portfolio while a shorter term using less risk, leans towards cash equivalents and bonds.
When considering the added element of expected returns, additional premiums are captured. This does not involve predicting which stocks, bonds, or market areas are going to outperform in the future but focuses on design. The goal is to hold a well-diversified portfolio that emphasizes dimensions of higher expected returns with low turnover.
Professor and Nobel Laureate Eugene Fama has contributed to identifying these dimensions. His hypothesis, “Efficient Capital Markets: A Review of Theory and Empirical Work,” showed that current prices incorporate all available information and expectations into securities prices. In the academic research of equity markets, the dimensions demonstrated are size (small cap vs. large cap), relative price (value vs. growth), and expected profitability (high vs. low). In the fixed income market, these dimensions are term and credit quality (1).
To create a well diversified portfolio a proper balance may be achieved by observing a multi-step process:
- Develop a personal investment plan by defining goals, tolerance for risk, and time horizons.
- Determine asset allocation by creating the proper mix of stocks, bonds, mutual funds, alternatives, and include global exposure-diversification.
- Seek out and capitalize on dimensions of expected returns.
- Monitor the plan. Evaluate your strategy and set specific times for revisiting the strategy, planning to review at least quarterly. Rule of thumb points to a rebalance on a regular time interval and usually upon a 10% drift. Keep in mind required tax efficiencies.
The markets aggregate a vast amount of dispersed information and drive it into security prices. By observing a well-diversified approach, disciplined risk managed strategies, and a focus on dimensions of expected returns, one may be better prepared for the next Nor’easter.
- source: Dimensional Fund Advisors