A diversified portfolio is a collection of investments in various assets that seeks to earn the highest possible return while reducing likely risks. A typical diversified portfolio has a mixture of stocks, fixed income, and commodities. Diversification works because these assets react differently to the same economic event.
Let’s now look at how to calculate the risk of the portfolio. The risk of a portfolio is measured using the standard deviation of the portfolio. However, the standard deviation of the portfolio will not be simply the weighted average of the standard deviation of the two assets. We also need to consider the covariance/correlation between the assets. The covariance reflects the co-movement of the returns of the two assets. Unless the two assets are perfectly correlated, the covariance will have the impact of the reduction in the overall risk of the portfolio.
In a diversified portfolio, the assets don’t correlate with each other. When the value of one rises, the value of another may fall. The mixture can lower overall risk because, no matter what the economy does, some asset classes will benefit. That can offset losses in the other assets. Risk is also reduced because it’s rare that the entire portfolio would be wiped out by any single event. A diversified portfolio is your best defense against a financial crisis.
- You receive the highest return for the lowest risk with a diversified portfolio.
- For the most diversification, include a mixture of stocks, fixed income, and commodities.
- Diversification works because the assets don’t correlate with each other.
- A diversified portfolio is your best defense against a financial crisis.
To Build an Investment Portfolio
Stage 1: Determination of the investment policy and type of the portfolio.
Understanding your current financial situation and choosing a corresponding investment policy and type of portfolio is a first step to building your investment portfolio. Generally speaking a newly-graduate at the start of their career should have a different portfolio strategy from a 60-year old married person with children.
Stage 2: Determination of the strategy of portfolio management.
There are two basic approaches for portfolio management including active portfolio management strategy and passive portfolio management strategy. The Active portfolio management involves higher than average costs and it stresses on taking advantage of market inefficiencies, while Passive asset management are low cost investments kept for the long term.
Stage 3: Analysis of assets and formation of a portfolio.
The general criteria for including assets in an investment portfolio are the ratios of their profitability, risk and liquidity. There are different ways to fulfil an asset allocation of your choice.
o Stocks
Buying a tiny percentage of company stocks promises to make profit from company growth, but the risk is high since they may also lose their value. To minimize risks, stock buyers usually use funds to invest in them.
o Bonds
Bonds are considered to be safer yet less profitable. They can also be referred to as fixedincome investments.
o Mutual Funds
In contrast to individual stocks buying mutual funds allows you to add instant diversification to your portfolio. Some of them need active management while others don’t. Index funds and Exchange-Traded Funds (ETFs), for example, try to match the performance of a certain market index. ETFs, like individual stocks, can be actively traded on an exchange during the trading day, while index funds can only be bought and sold for the price set at the end of the trading day.
Stage 4: Measuring portfolio performance
Stage 5: Rebalancing your portfolio on time
You need to evaluate the effectiveness of a portfolio in terms of comparing the factually obtained profitability and risk. Portfolio returns are only a piece of the whole. Without evaluating risk-adjusted returns, an investor cannot possibly see the whole investment picture.
Over time your investment goals may change or your previously chosen allocation may be ruined. Audit of a portfolio is vital in order not to make its content contradict the already changed economic situation, the investment quality of securities and the goals of an investor.