Reducing market volatility through diversification

Understanding the factors behind diversifying your portfolio

At WealthFactor, we subscribe to what the industry calls evidence-based investing. Evidence-based investing is simply taking each component of the investment process and filtering it through facts. This is at odds and a sharp contrast with what goes on in the media and on wall street which is constantly projecting the idea we should be trying to pick stocks and time markets. I am not aware of any evidence that suggests trying to do either of these things will result in better investment outcomes.

One of the proven ways to reach your long-term financial goals is through an investment technique known as diversification. Diversification basically means spreading out your invested money across different investments types, industries, countries, etc., which can smooth out the performance of your portfolio and may lead to stronger returns over the long term. At WealthFactor we often employ an investment technique called direct indexing. When we build a portfolio based on an index we often will identify that the index is concentrated in specific sectors or industries and we through our systematic process will reduce that in favor of better diversification in our client portfolios.

One of the guiding factors behind diversification is that not all investment categories perform well at the same time; as some are increasing in value, others may be decreasing. The movement up and down of investment categories is referred to as market volatility.

Maintaining a well-balanced portfolio

To maximize the probability of investment success one must reduce the risks associated with market volatility by creating a portfolio that effectively diversifies your investments. Essentially, a portfolio should represent a collection of different investments that work in harmony.

One way you can achieve portfolio diversification is to divide your investments among the major asset classes – namely, equities, fixed income and cash.

Asset classes – A range of risks and rewards

Each asset class comes with varying degrees of risk and return characteristics, and typically perform differently in certain market environments. Here’s a quick summary of each.

 Equities (e.g., stocks) Equities refer to buying stocks or shares of a business, making you a part owner. This means you are entitled to profits when stock values increase, but are also subject to the risks of declining stock value if companies underperform.

· Fixed income (e.g., bonds, Treasury bills) Fixed income investors lend capital in exchange for interest. Considered as creditors, bondholders often have a priority claim in case of company bankruptcy or default, making the investments less risky. Fixed income typically provides income at regular intervals.

Cash (e.g., money market funds, bank accounts) Cash investments provide low returns versus other asset classes, in the form of interest payments. These investments typically come with very low levels of risk.

Investment funds – One-stop diversification

In some instances, especially with international or emerging markets exposure it’s often most efficient to achieve diversification through the use of investment funds. There are multiple types of funds. The most common are mutual funds and exchange-traded funds (ETFs). These investment vehicles represent convenient and affordable ways to access a wide range of investments.

ETFs – These are funds that track and seek to replicate the performance of select market indexes. Because ETFs represent a basket of securities based on the underlying index, you can gain broad diversification across entire markets, industries, regions or asset classes. ETFs are known to incur fewer administrative costs (and therefore charge lower fees to investors) since they’re simply tracking an index without trying to outperform it.

Mutual funds – These are made up of a pool of assets from many investors and managed by a portfolio manager. We view mutual funds as almost always a deeply inefficient tool and never use them in client portfolios. The only exception to this is when you have very small amounts to invest and any transaction cost associated with making the purchase would be impactful.

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