Tuesday, June 4, 2019

Recap: Why Diversification Is Important?

These past few weeks had been tumultuous: the trade war was still ongoing between the United States (U.S.) and China; telecoms giant Huawei was bearing the brunt of the clampdown by the U.S.; and just recently the U.S. president had tweeted, against expectations, that Mexico would be the subject of tariffs.

The equity markets, which are deemed to be sensitive to such macroeconomic and geopolitical events, took a dip. If you are at a loss at this juncture, you could read up an earlier piece on what to do when a trade war happens. On top of that, I will show you another way to go through the storm, and that is diversification.

Diversification Is A Natural Hedge

Experienced investors and traders often use hedging strategies to minimize their losses and risks. Derivative financial instruments such as futures, options and contracts for difference (CFDs) are the common tools used for hedging. Short-selling (or shorting) a counter is another way. While they have their good uses, I would not recommend the above hedging strategies if you either do not understand them and/or not sure how the markets are going to move next (which is next to impossible).

Though some may see diversification as a very slow hedging tool, it does work to a certain extent and it is simple to understand. What makes this possible is this thing called correlation, which is how various asset classes, regions and countries, sectors and/or companies would move in relative with one another. However, for this to work optimally, you must have a portfolio with different asset classes (not just equities only) to begin with.

Using the Bedokian Portfolio’s five asset classes and taking a cue from my go-to portfolio analysis tool Portfolio Visualizer, let us look at the correlation of the various ETFs representing the different asset classes and cash in the U.S. market from 1 Jan 2019 to 31 May 2019:

Vanguard Total Stock Market ETFVTI-0.64-0.490.06-0.08
Vanguard Real Estate ETFVNQ0.64-0.280.560.22
Vanguard Total Bond Market ETFBND-0.490.28-0.230.21
SPDR Gold SharesGLD0.060.560.23-0.64

Fig. 1: Correlation table of the five Bedokian Portfolio asset classes, 1 Jan 2019 to 31 May 2019. For full set of data see here

As with the fluidity of the financial markets, such correlation numbers are not hard fixed to one another and will change. Sometimes the asset classes may seem positively correlated, but there are other times where they are negatively correlated. The main gist is all of them correlate with one another differently, and that is why diversification is a natural hedge, since the aim is also to minimize risks and losses.

A caveat though; there is no such thing as a 100% foolproof hedge. If there is such, I would really want to know what and how to do it.

A Hedge For Passive Investing

Passive investors make use of the natural hedging in diversification by rebalancing their investment portfolios. 

Equities coming down due to the trade wars and tariffs? No issue. Let us see how things are like in my next rebalancing date. If my equities portion is below my benchmark, I can just either sell those asset classes that are above their benchmarks and buy more equities, or with my cash injection I would simply adjust the portfolio back to their respective proportions.

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