The financial landscape is filled with countless investment opportunities, each with varying degrees of potential for profit and risk. Diversification and margin trading are two key strategies used in investment portfolio management, each serving a unique purpose in the journey towards financial growth and security.
Deciphering Portfolio Diversification
The principle of diversification is anchored on spreading investment risk across a range of assets to mitigate potential losses. Despite this well-known benefit, many investors grapple with understanding what proper diversification looks like.
Portfolio diversification should involve exposure to multiple asset classes - equities and bonds being primary ones. Within these classes, exposure must extend to various subsets. For instance, an equity portfolio should feature stocks of varying capitalizations, such as Large Cap, Mid Cap, and Small Cap, and from different geographical areas like Europe, Developing Markets, and Emerging Markets.
In the realm of Fixed Income, an investor should ideally hold a mix of short-term and long-term bonds, government and corporate bonds, and bonds across various rating scales from AAA to junk.
Moreover, significant portfolios may consider exploring additional asset classes like Hedge Funds, Real Estate, Commodities, and Venture Capital. These options, once exclusive, are now accessible through low-cost ETFs, Mutual Funds, and online co-op private equity groups, making diversification more attainable for the everyday investor.
The Challenge of Predicting Performance
Predicting the future mix of assets is challenging. It is essential to remember that an asset class's recent stellar performance is not indicative of continued success. This uncertainty is encapsulated in the industry’s oft-repeated disclaimer: "Past performance is not a guarantee of future results.”
For instance, if Growth Stocks have outperformed Value Stocks in the last year, it is likely that this trend will reverse in the following year. Similarly, if Small Cap stocks performed better than Larger Cap stocks this year, it is plausible that the scenario will flip next year.
Investors should be wary of year-end articles boasting titles like "The Best Mutual Funds of 20—." Historical patterns have shown that the best performers of one period often fail to retain their position in the subsequent one.
Exploring the World of Margin Trading
Margin trading is another significant aspect of portfolio management. This strategy involves borrowing money from a broker to purchase more securities than one's current financial position would allow. This approach allows investors to leverage their existing portfolio to achieve potentially higher returns.
However, margin trading also carries substantial risk, as it increases potential losses. If an investor's margin securities decline significantly in value, they might face a 'margin call', requiring them to deposit more cash or sell off securities. Therefore, investors need to balance the potential high rewards of margin trading with its considerable risk.
A well-diversified portfolio is crucial for spreading risk and optimizing returns. While margin trading offers a route to amplify gains, it also introduces a greater level of risk. Striking a balance between diversification and strategic risk-taking is key in mastering portfolio management and achieving long-term financial goals. Proper financial planning and regular portfolio review can help in maintaining this equilibrium.
Summary
Diversification is intended to reduce the volatility of price movements in individual securities, but many people are not sure what proper diversification looks like.
It depends.
You should definitely have exposure to at least two asset classes: equities and bonds. Within each asset class, diversification is also important. In your equity portfolio, you should have exposure to stocks with various capitalizations (such as Large Cap, Mid Cap, and Small Cap), various geographical areas (such as the Europe), Developing Markets, and Emerging Markets.
In your Fixed Income portfolio, you should have exposure to short term bonds and long term bonds, government bonds and corporate bonds, AAA rated bonds and junk bonds, and so on.
The idea is to spread your exposure and upside potential across many assets, where their movements are correlated to some extent but different assets will hedge against losses in the others. If your portfolios are of a significant size, you might look to additional asset classes such as Hedge Funds, Real Estate, Commodities, and finally, Venture Capital.
Even for everyday investors today, exposure to these formerly exclusive asset classes is now accessible through low-cost ETFs, Mutual Funds, even co-op private equity groups that can be found online with minimal initial investment levels.
It is not easy to determine the right mix of assets, because this requires predicting the future. The most important thing we want to warn you about is that most of the time, an asset class which has performed very well in the recent past is not very likely to continue to perform as well in the following years.
As we like to remind people in this industry with the disclaimers in many prospectus packets, “Past performance is not a guarantee of future results.” For example, if during the last year, Growth Stocks outperformed Value Stocks, it is very likely that the situation will be reversed the following year. If Small Cap stocks performed better than Larger Cap stocks, it is very likely that next year, the situation will be the opposite.
Beware of December articles with titles like “The Best Mutual Funds of 20—.” We can almost guarantee that you will not find a majority of these funds on next year’s list.
For example, growth stocks were the best performers for four years (1995-1998) but were the second worst choice for the following four years.
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