Trading Assets

Strategic Portfolio Diversification

08 Feb 2024
Portfolio diversification is a risk management strategy that involves investing in a variety of different assets to mitigate the risk of poor returns or losses. It's a way of avoiding the "all eggs in one basket" scenario, aiming to make investments safer by including different types of financial assets. This strategy is based on complex mathematical theories, including correlation, variance, expected return, and expected value.  

 Types of Diversification in Portfolio Management: 

  •   Currency-Related Diversification: Involves including instruments with different reference currencies in the portfolio.  
  •   Geographical Diversification: Achieved by investing in various geographic areas around the globe.  
  •   Sectoral Diversification: Focuses on various cyclical and defensive sectors.  

 Importance of Portfolio Diversification: 

  •   Risk Mitigation: Diversification helps limit exposure to risk and protects the portfolio from individual bankruptcies and market shocks.   
  •   Increased Chances of Earnings: Owning a diverse range of assets can expand opportunities for potential earnings.   
  •   Avoiding Concentration Risk:Prevents excessive focus on specific assets, reducing the risk of significant economic loss.  

 Portfolio Diversification and Correlation:  

  •   Expected Value: The average value of a random phenomenon.  
  •   Variance:Indicates how much an actual value deviates from the forecasted value.  
  •   Correlation:The relationship between two variables, indicating how one variable corresponds to another.  
  •   Correlation in Diversification:Diversification involves creating baskets with little or no correlated securities to minimize mutual influence.  

 Portfolio Diversification Strategy:  

  •   Diverse Investments:Includes shares, commodities, forex, indices, and bonds.  
  •   Evaluation of Correlation:Assessing how different assets within the portfolio influence each other.  
  •   Decreased Volatility:A well-planned diversification strategy reduces volatility and drawdown, increasing profitability.  

 Portfolio Diversification Example: 

  •   Harry Browne's Model:  
    •   Divides the portfolio into four parts:  
      •   25% shares  
      •   25% gold  
      •   25% short-term government bonds  
      •   25% long-term government bonds  

 Beta and Systemic Risk:  

  •   Beta Value:Indicates the behavior of a security or portfolio in relation to the volatility of its benchmark index.  
  •   Interpretation:  
    •   Beta of 1: Moves in line with the market.  
    •   Beta > 1: Moves with higher volatility than the market.  
    •   Beta < 0: Moves in the opposite direction of the market.  
  •   Significance in Diversification:Beta helps understand how much a security is exposed to systemic risk.  

 ETF Portfolio Diversification: 

  •   ETF Trading:Effective tool for portfolio diversification.Involves trading ETFs to gain exposure to various asset classes without purchasing multiple equity lines.  



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