Saturday, July 1, 2006

Ways to Diversify Your Investment Portfolio

"Behold, the fool saith, 'Put not all thine eggs in the one basket' which is but a manner of saying, 'Scatter your money and your attention' but the wise man saith, 'Put all your eggs in the one
basket and... watch that basket.'"

- Mark Twain, Pudd'nhead Wilson, 1894

A well embraced tenant of prudent investing is to diversify your investment portfolio among different types of assets which may respond differently to various economic conditions. Diversification is an effective risk management tool in helping reduce investors’ exposure to a downturn in any one sector.

Notwithstanding the spirit of truth in Pudd'nhead's maxim, a sentiment echoed by Warren Buffet who once said "Wide diversification is only required when investors do not understand what they are doing," proper diversification is a proven method to improve the long-term probability of upside performance as well as downside risk exposure. The key is knowing how to diversify properly. In this blog we delve deeper into the concept of diversification to present the importance of allocation among uncorrelated assets as well as investment strategies.

The term “asset class” describes a group of securities that shares similar risk and return characteristics such as: cash equivalents, fixed income, and equities. Additional diversification can be achieved by blending different categories contained within each asset class. For example, equities can be divided into large-, mid- and small- market capitalization stocks; economic sectors such as energy, healthcare or technology; geographic regions (domestic vs. international); or investment styles (growth vs. value). Fixed income is typically separated into groups designated by the type of issuer, credit quality and maturity.

Beyond asset class distinctions there are several approaches to investing which require differing levels of active management based on assumptions about the investor’s risk tolerance and changes in market expectations. Popular forms include the “buy and hold” strategy in which an investor determines an initial allocation and then holds this portfolio throughout market fluctuations without making adjustments. Another approach is “strategic asset allocation” which requires the investor to make periodic adjustments to restore the portfolio to the targeted mix. And then there is “tactical investing” where the investor actively changes investments to reflect his or her own shorter-term capital market expectations.

An ongoing debate among investors is the extent to which asset class exposure is the primary driver of risk and return, versus to what extent does an active/tactical approach to investing play a positive, negative or neutral role in managing risk and return.

The demise of the unprecedented 1980s/1990s bull market in equities left many sophisticated investors disputing the case for a pure “buy and hold” strategy. Based on institutional demand for hedge funds, these investors have established their growing interest in investment alternatives, particularly “absolute return” programs that generate “alpha” or skilled-based returns that exceed the performance of the financial markets.

Since the late 1970s certain savvx investors have taken advantage of an array of alternative investment approaches vis-à-vis a niche strategy called “managed futures.” These sophisticated investors realize that superior traders operating in this specialized universe offer an outstanding tradeoff between risk and return. They are attracted to the incremental and often non-correlated returns that such investment can provide beyond exposure to traditional asset classes or investment strategies.

Academic research and a growing body of investment theory has shown that assets should be compared on a risk-adjusted basis (e.g., mean return/standard deviation) and that the potential benefit of adding an asset to an existing portfolio may be measured by an asset’s excess breakeven return. Because the correlation between managed futures and most traditional investments is extremely low, when portfolios of traditional assets are combined with managed futures, the result is a reduction of risk (i.e., standard deviation) to the overall portfolio.

Growth in investor demand for managed futures products indicates appreciation of the benefits this strategy can add to a diversified investment portfolio. However, it should also be noted that there is a high degree of leverage that is often obtainable in futures trading that can work against you as well as for you. Because the risk of loss in futures can be substantial, you should carefully consider whether such trading is suitable for you in light of your financial condition.

- Mack Frankfurter, Managing Director

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