Protecting your Financial Portfolio against Market Volatility – Diversification

What is Market Volatility?

The stock market never stands still. Indices and stocks experience gains and losses daily. In stable markets, these indices and stocks move less than 1% either way. Market volatility occurs when there are drastic price changes (more than 1%) to an index or stock.

Market volatility can be defined as the frequency and magnitude of price movements. If large movements occur frequently, then markets can be considered volatile. Stocks or indices that are often volatile could be regarded as riskier than more stable assets. The riskier a stock or index is, the greater the chance of losses.

Market volatility is a normal part of long-term investing and should be expected. Long-term investing allows for higher-risk funds and equities as the portfolio has the advantage of the time to ride the ups and downs or volatility in the market. Shorter investment terms usually consist of lower-risk funds and equities.

What is Diversification?

Diversification is the process of spreading investments in a portfolio across a variety of fields to mitigate the chances of losses. It is a management strategy to reduce risk in investments. The idea is to own a variety of investments with different characteristics with the purpose of reducing volatility. This limits exposure to any single one asset or risk.

What kinds of Diversification are there?

Diversification can be divided into various asset classes, sectors and geographic regions.

·?????? Asset classes

Diversifying across various asset classes is an excellent way to spread risk in a portfolio. A fund manager would determine the percentage of asset class in a portfolio according to a risk profile.

Factors that may negatively influence one asset may benefit another. This helps spread the risk of the portfolio.

Asset classes include:

?Equities or stocks are typically stocks of companies. They generally have a higher risk but also a?higher return potential.

Bonds are government and corporate fixed-income debt. They are generally more stable risk investments with guaranteed fixed returns, albeit lower than equities. An investor nearing retirement usually invests in more bonds to reduce risk and preserve capital.

Cash includes treasury bills, money market solutions and other low-risk investments.

Real Estate could include commercial and residential properties.

Commodities like gold, maize, wheat, sugar, natural gas etc.

·?????? Sectors

This method of diversification spreads investments over sectors. Sectors or industries operate differently from each other and react differently to markets. Investments diversified across industries are less likely to be impacted by sector-specific risk.

Sectors include information technology (Meta, Nvidia, Apple, Microsoft, etc.), healthcare (Johnson & Johnson, Pfizer, etc.),?financials (banks, financial services, etc.), consumer discretionary (hotels, restaurants, entertainment, vehicle etc.), communication services (telephone and internet providers, Disney, Netflix etc.), industrials (transportation, airlines, construction, aerospace, manufacturing etc.), consumer staples (Nestle, Coco-Cola, Unilever etc.), energy ( wind, renewable energy, fossil fuels etc.), utilities ( electricity, water, sewage removal etc.), real estate (property management, land, commercial, industrial, residential etc.) and materials (mining, forestry etc.).

·?????? Geographic Regions

This means holding investments from different regions. As an investor, you don’t want all your money in one country or region in case of failure. Spreading investments across various regions allows you to reduce portfolio risk by avoiding overconcentration in one area. For example, a portfolio that invests heavily in Asia may suffer significant losses if China or Japan’s economy were to go into a recession, while including the US and Europe in the portfolio would allow for more stability.

Some regions are more economically stable than others. The US and European economies are more reliable and historically stable, whilst emerging Asian, African and Latin American markets are still volatile.

Diversification through regions could include the US, Europe, Great Britain, Asia, Australasia, the?Middle East or South America.

How does Diversification protect your Investments against Market Volatility?

In layman’s terms, it means not carrying all your invested “eggs” in one basket. By holding several baskets of eggs, you are spreading the risk of losses if one basket falls.

Diversification is an important risk management strategy that reduces a portfolio’s volatility while not compromising profits.

It’s not just about choosing a mix of assets, sectors or regions. A portfolio manager looks at the kinds of companies in the asset classes, sectors and regions.

Some companies are in their high-growth phase and tend to be newer companies that could offer different risk and return characteristics than older, more established companies. These companies generally have higher valuations and higher returns, e.g. Nvidia. Value companies have slower growth and are more established but offer more stability.

In asset classes, the equities class have a higher potential for growth but also a higher risk factor, while bonds are more stable and offer lower fixed returns. A higher equity percentage in a portfolio means the investor wants to grow their portfolio and is prepared for higher risk to get higher returns. A portfolio with fewer equities and more bonds might mean investors want to preserve their capital. Often, a younger investor will have higher equities to grow their portfolio, while an older investor wishes to preserve the capital they have accumulated for retirement.

A portfolio manager will look at an investor’s risk profile and select funds accordingly. Higher risk means investing more in equities that are performing well, like companies in the big tech, financial, and energy sectors.

These diversification strategies are designed to lower a portfolio’s overall risk against market volatility and global uncertainty. This long-term strategy will smooth out the ups and downs in a portfolio caused by volatility while offering good long-term returns.

Example of Diversification

Most big tech companies like Microsoft, Meta, Google, Apple, Alphabet, Nvidia, energy and oils companies like Chevron or banks like JP Morgan are US-based and offer significant returns between them. Sector-wise, they are spread out or diversified, but not geographically. If the US were to have a recession, all these US-based companies could perform poorly.

A financial advisor or portfolio manager will diversify over various sectors and regions. For example, big tech companies in the US, Europe and Japan, banks in the US and Europe, and oil and energy companies in the US, Middle East, Europe, China and South America.

Then, various asset classes like equities or stocks in companies in different sectors and regions, as well as bonds in different companies and governments.

Fortunately, most funds or indices that portfolio managers invest in are already diversified and proactively managed by expert fund managers.

Diversifying a portfolio over various combinations of asset classes, regions, and sectors, can lower the overall risk of losses a portfolio may encounter due to volatility. It is important to consult with a financial advisor to review investment portfolios and ensure that they are suitably diversified.

Please note, the above is for educational purposes only and does not constitute advice. You should always contact your deVere advisor for a personal consultation.

* No liability can be accepted for any actions taken or refrained from being taken, as a result of reading the above.