Diversification – Balancing Return and Risk

In my last few post I have touch on two of the three parts of the basics of asset allocation – risk and return, In this post I cover the third part - Diversification . Diversification will help you see how to balance risks and returns into an intelligent strategy.

No one, alas, can eliminate all risk in investing. But by diversifying, you can at least minimize it. There are two ways to diversify.

Real Estate and Bonds
First, you can partially or completely offset your risk by investing in a number of different areas. Let’s say, for example, that you use some of your investment Ghana cedis or dollars to purchase a small apartment building. At the same time, you buy a high-grade cooperate bond.

Your real-estate investment provides a hedge against inflation. As prices rise, the value of your building rises, too. But its value could fall considerably during a prolonged deflationary period.
The value of your bond however, would respond in exactly the opposite way to either inflation or deflation. Inflation would lower the value of the principal you invested in the bond as well as the value of the interest the bond issuer promises to pay you. The effect of deflation, on the other hand, would be to raise both the price you could get for the bond and the value of the interest payments.
What’s important to note is that any change in the value of your building brought on by inflation or deflation probably will be offset by an opposite change in the value of your bond.

So, neither inflation nor deflation would prove disastrous. And if neither of these economic condition become a serious threat, both you building and your bond will still generate healthy returns. You’re braced against the harsh winds of economic change but positioned to profit in the calm of stability.

The second way of diversifying: spreading you holdings in anyone investment area- especially when buying real estate and common stocks, when you diversify by buying shares in a number of companies, say, or several parcels of real estates, your return is more likely to approach the average for that investment category rather than the return on any single investment.

Now that we’ve covered the basics of asset allocation – risk, return, diversification – its time to see how to balance these elements within an intelligent strategy. That’s what I will be touching on in my next post.



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Types of Risk

Investment risk falls into a number of categories. But bear in mind that any one investment can be subject to more than one type of risk.

Inflation Risk
Inflation risk refers to the loss of value in your investment caused by increasing depreciation of the currency. A constant rate of inflation, even if is high, is not risky. When you purchase a long-term bond, for instance, the price of the bond, and therefore its yield, already reflects the current inflation rate.
Rather, it is a rise in the inflation rate that is the source of risk. For example, you buy a long-term bond when inflation is low. If the inflation rate rises, both your bond’s resale value and the value of the interest you receive will decline. After all, the same Ghana Cedi or Dollar is worth less when inflation is high than when it is low.

Deflation Risk
Deflation risk is, not surprisingly, just the opposite of inflation risk. It is the risk that the value of our asset will decline when general prices levels fall during periods of severe recession or depression. Land that you buy during boom times, for instance, may lose value during a serious recession.

Business Risk
Business risk refers to the chance that some event might occur that reduces or destroys a particular investment’s return. For example, you might buy stock in a company that has perfected a pill to cure the common cold. Than a competitor develops a vaccine that prevents cold entirely. Your company’s product becomes obsolete.
Business risk can be more widespread – and more difficult to control. For example, changes in government policy, war, or erratic weather could suddenly wipe out the profits of the cruise ship company whose stock you just bought.

Interest Rate Risk
Interest rate risk is the decline in market value that occurs when the interest rate on new, similar investments rises. For example, you buy a five-year corporate bond paying 8 percent interest. The next year rates rise, and the same five-year bond fetches 10 percent interest. The value of your bond declines.

Market Risk
Market risks refer to the chance that an entire financial market may suffer a decline. Say you buy stock or shares in a prosperous company, but the entire stock market falls sharply in value as it did this year (2009) in Ghana, the US, UK and across the world. Your company is still doing well, but investors are wary of stocks and shares in general, so the price of stock or shares you bought drops.

Illiquidity risk
Illiquidity risk refers to the loss you might have if you’re forced to sell an investment before you had panned. Perhaps you have an unexpected medical expense and much sell some real estates in a hurry to raise the cash. You’ll have to take what the market will give you for your property, because you can’t wait for a better price.

The question, now that you know what the different risks are, is what you can do about them. The answer, in a word: diversify! – Diversification will be the focus on my next post

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