The amount of risk in an investment is the main determining factor as to whether an investment opportunity should be pursued or not. Every rational investor seeks an investment type where the risk (probability of loss) is adequately compensated by the returns from the investment. In simple terms, we say, the higher the risk, the higher the return from the investment.In all cases, the risk in an investment venture is not avoidable. At some point during the investment cycle, the investor or the investment manager will have to come up with ways of managing or nullifying the risk that proves unavoidable. Risk diversification is one of the ways of managing the type of risk that cannot be avoided, eliminated, or transferred to an insurance company.
Diversification is when an investor opts to distribute his wealth to buy/acquire, hold, and operate various assets in different sectors of an economy. In the event profits are affected in one sector of investment, say agriculture, the investor can rely on the investment made in other sectors such as mining, transport, or energy.The investment sectors preferred for diversification must show some form of non-correlation in the performance of certain market parameters such as the price of goods. As an illustration, in a well-diversified pool of investments, when the income from agricultural production falls from an irregular water supply, income from a non-correlated sector such as mining should remain relatively sound to absorb losses generated from the agricultural investment.
One way of protecting the value of an investment portfolio is by injecting cash into investment sectors with zero performance correlation. What is the correlation in investment assets?Normally, the forces of demand and supply will alter the performance of many kinds of assets in different investment hubs. Two types of assets are said to be correlated when these forces of the market cause similar trends in product pricing for the two assets in consideration. Any two assets are said to be correlated when they are affected similarly by a given market force.
The magnitude of correlation also matters during diversification. The magnitude of correlation measures the extent of variation one asset has on the price changes of the correlated asset. When the measure of the correlation between two assets is zero, then the implication is that price changes in one asset does not affect the price of the other asset.In extreme situations, the measure of asset correlation can be a negative figure. When correlation is a negative number, the implication is that an increase in the product price of one asset will cause a drop in the price of the negatively correlated asset; price movement between the two assets will occur in different directions.
The problem of investing in heavily correlated assets is common among rookie investors. Most of these investors do not clearly understand the price correlation of all the assets in their investment portfolio. For instance, stock and bond prices are highly correlated and are almost always similarly affected by market forces; a fall in stock prices is often corresponded by falling bond prices.The risk of loss or portfolio failure is higher and widespread across a portfolio of highly correlated assets. This is the premise for advocacy for portfolio structuring using non-correlated assets.
Common types of non-correlated assets may include, but not limited to:
- Real Estate Investments including Real Estate Investment Trusts
- Bonds issued in a majority of the emerging markets
- Gold and other valuable gems and stones
How to Determine the Ideal Non-Correlation between Assets
It is quite theoretical to achieve 100% non-correlation between assets in a portfolio especially in this modern and very dynamic business environment. This exercise is harder for an investor without technical and professional knowledge to measure correlation and non-correlation between assets of a given economy.Max Funding Business Analyst, Shane Perry says, “For most of the investors lacking the professional knowledge and capacity, we are better off depending on trained and competent investment advisors to guide us in determining the ideal diversification in a pool of assets based on mathematical and scientific correlation analysis.”She adds, “Generally, a portfolio of stocks, bond and real estate is a rather stable and less volatile investment pool. Gold is also a good hedging asset as many people opt to store wealth in gold when the prices in the stock markets are falling.”
Is Diversification Sound Investment Advice?
The simple answer is yes. However, it must be done using the right combination of the ideal assets. By and large, many different assets perform differently; prices and income in one or more assets will rise while the income and pricing of other assets are falling. This is characteristic of many investment markets.It makes sense, therefore, that informed and shrewd investors exploit to profit or benefit from such non-correlation in asset pricing provided the assets selected for diversification conforms to the investor’s appetite for risk and overall investment goal.
How Can One Benefit From Diversification?
Allows an investor to complement investment made in one field – Diversification allows an investor to rely on income generated from asset A investment when investment B fails if asset A and B are non-correlated and diversified together in one pool.
Capital Growth – When executed correctly, diversification will ultimately save capital losses at the time of maturity of the investment. Overall, diversification is a method of capital preservation.
Potential to earn high returns – There are higher returns in a diversified pool of investment compared to a single investment especially in the likely event all the assets in the diversified pool all perform positively.