Diversification reduces risk
In an environment full of uncertainties and temporary turbulence, it is very important to have good diversification in investment portfolios. The most common mistake many investors with a lack of information and knowledge make is focusing on investments in their domestic markets and persisting in the same habits even if the environment has changed. This causes an unnecessary concentration of assets. It is common knowledge that asset diversification reduces volatility and mitigates maximum loss, which is crucial in difficult market environments. Unfortunately, well-diversified portfolios do not abound in private banking.
Some practices may lead to sacrificing diversification to reduce management fees, which is a major form of negligence. Other non-professional investors invest directly in a limited number of individual securities. This is not a recommended strategy. For example, in equities, between 20 and 40 shares are needed to obtain optimal diversification. It may seem counterintuitive, but in the fixed-income asset class, even more titles are needed to obtain ideal diversification.
It is no coincidence that many fixed-income funds have hundreds of securities in their portfolios to reduce idiosyncratic risk and to manage exposures to different regions, sectors, and styles. By definition, bonds have low and limited return potential. Unlike stocks, bonds offer no possibility that a stellar return can offset a default. Therefore, each position must be small enough that a default does not have a significant effect on performance. Given the high minimum requirements for bonds, it is virtually impossible for individual investors to build efficient portfolios. In addition, limited access to derivatives makes risk management and duration difficult. The investor should use mutual funds in fixed-income portfolios, especially in high-yield segments such as emerging markets, mortgage-backed securities, bank loans, catastrophic bonds, and hybrids.
In general, many investors and even financial advisers spend too much time selecting individual titles. Studies show that asset allocation, not the selection of securities, is the most important factor in performance attribution. Approximately 80% of total long-term yield is due to the allocation of assets, specifically the weighting of cash, fixed-income, variable-income, and alternative investments. It is very important to have exposure to alternative investments, which typically have little correlation with traditional assets. This gives investors important protection in times of crisis and improves performance, given a certain volatility objective. Alternative investments include hedge funds, real estate, and private funds.
Adequate asset allocation and diversification allows for maximization of the return potential, given a certain risk tolerance. It is very useful to establish a long-term financial objective with a transparent policy on volatility and maximum tolerated loss. Only with a high level of discipline can investors avoid panic and overreactions in moments of stress. Emotions are the number-one enemy of successful asset management. Sometimes investors are paralyzed by not wanting to create losses or sell winners too soon. The problem is that keeping assets that have a bad dynamic—the losers—can lead to more dramatic losses. Aversion to loss is a psychological reality that leads investors to commit irrational errors. In the long term, individual investors can only succeed if they diversify and if they act logically, with clear objectives and without emotional attachments. This is not easily achieved without professional advice.
How the asset allocation is specifically implemented in different portfolios obviously depends on the time horizon, individual objectives, risk tolerance, and liquidity need of each investor. For example, an investor or a family with a median horizon of five to seven years with a medium or high risk tolerance could choose a balanced profile, in which we recommend approximately 5% in cash, 25% in fixed-income investments, 35% in equites, and 35% in alternative investments, well diversified in each segment.