Many investment experts suggest that diversifying your assets is the easiest and best way to reduce risk and increase your profits. However, as easy as it sounds, it is not the only way to get better returns. There’s a fair amount of risk involved in diversification, not to mention the compromises in profits if a particular sector is doing better than others.
In such times, what you need is not the diversification of your assets but your investment strategies. Adopting different strategies based on different situations can help you sail through rough market situations. The dynamic nature of strategies will empower you to modify your portfolio for attaining high returns.
Why Diversification in investment strategies could be useful
- Value investing – this involves picking up securities that have been undervalued or under-priced by finding the intrinsic/hidden value of a stock.
- Growth investing – this constitutes investing in above-average growth avenues even if the share price appears to be expensive. It is based on capital appreciation.
- Income investing – this strategy includes investments done with the purpose of generating a steady income out of it.
- Small cap investing – here, investments are made in relatively small cap companies to achieve high returns.
- Socially responsible investing – this strategy provides you with an opportunity to bring social/environmental good along with achieving financial returns on your investment
For choosing a suitable diversification strategy, you need to go by the fundamentals and ensure diversification in baseline conditions and return drivers. A baseline is a standard that is used as a base for measuring or comparing current and past values. For instance, a company wanting to measure the success of its product line can use the number of units sold in that product line during the first year as a base and evaluate subsequent growth in sales. These parameters would, thus, ensure that the different assets of your portfolio remain independent of each other, minimizing the risk via diversification.
The first thing you need to do is to identify the baseline conditions and the factors that affect different assets’ performance. Once these are identified, you can easily draw relations in understanding how they correlate with each other and use them for the diversification of your portfolio.
Plan a trading strategy after analyzing the drivers and on-going market trends. Together, the two of them help in formulating the best of strategies.
Here’s why diversification in assets could be a risk
Often, different asset classes are correlated to each other in a manner that if one of the asset class tanks, it impacts other asset classes as well. This effect, where a decline in the price of one asset class impacts several others nullifies the idea of diversification.
To analyze this further, let’s have a closer look at this. Say you have invested in different asset classes: A, B, and C.
In a case where asset class B is going through a rough patch, ideally according to diversification, other asset classes should remain unaffected and in that case, you end up losing only a limited part of your investment.
However, one thing which often gets ignored is the “driver” factor. Say asset class B indirectly is associated with the asset classes A and C, this would mean that any fall in the former class will surely affect the latter two in some proportion.
Here, although the asset classes appear to be different, they are interlinked via return drivers or baseline conditions. This brings in the risk factor, which is otherwise assumed to be eliminated, making diversification in the asset class a risky affair.
In a nutshell
Diversification of strategy could be easily achieved by using a permutation and combination of various strategies and identifying independent driving factors and baseline conditions. This way you can work towards increasing your profits without having to diversify your assets every time there’s an opportunity or challenge the market throws at you.