Diversification in a Portfolio - Research Paper Example

Diversification in a Portfolio Introduction Due to the need for higher returns on investment in the current market, investors andentrepreneurs have adopted several strategies to ensure that they achieve their goals. These strategies that have been employed by investors vary from market to market and from region to region. Diversification of portfolios has emerged as one of the common ways employed by investors in order to reduce the risks on their investments with an aim of maximizing their returns. Various researchers have studied the effect of diversification of portfolios on returns and risk factors of an investment. Graham (2010) observes that the risks of an investment are reduced to between 80-90% through diversification of portfolios. However, there have been questions as to whether portfolio diversification is the best way to increase returns of an investment and to yield higher returns. Some studies have shown that portfolio diversification only reduces non market risks when the diversification is done up to a certain degree. According to Hagin (2004), even though portfolio diversification reduces non market risks and increases the returns of an investment, the rule of diminishing returns usually applies at a very early stage of the investment. This paper therefore tries to answer the question as to whether diversification of portfolios with aggressive and defensive risks profiles the best way to invest. In order to answer the main question of the paper, the paper reviews the various aspects or factors that are involved in an investment and determines how they correlate with diversification and returns. Portfolio and Portfolio Diversification Portfolio can be broadly defined as a collection of various financial assets that are owned and managed by an individual investor or a group. According to Hagin (2004), portfolio refers to combination of different investments assets that are mixed with the aim or purpose of achieving the goals of an investor or a group of investors in any given market and region. Some of the financial assets include equities, liquid assets, fixed income instruments, bonds as well as cash. The kind of portfolio an investor chooses strongly determines the risks and returns associated with that particular investment. Diversification of portfolios on the other hand refers to an investment strategy that involves mixing of various assets in order to reduce the risks of an investment portfolio. This is through the spreading out of the risks that are associated with each investment assets to ensure that when a financial crisis occurs or affects one asset, the other assets are able to absorb this shock and this will ensure that the investment portfolio is not hugely dented. Portfolio diversification is basically centered on the noble idea and thinking that different investments tend to perform differently at every given time and point. With this understanding, it is possible to see that when there is a decline in one area, not all areas will suffer. Diversification of portfolios therefore spreads the risks of a catastrophic financial crisis on an investment. The process of diversifying portfolio depends on each and every investor and group. Portfolio diversification is usually an extension of the financial plan of an investor. This is because the way an investor decides to divide his investment categories will purely depend on his or her risks tolerance as well as the time horizon for needing to use the money. This gives three categories of portfolios. The first portfolio is that associated with the aggressive investment strategy. This strategy is associated with investors who normally expect the highest possible returns from the market that they decide to invest in. These kind of investors therefore shoot with the aim of getting the best possible from the market. This category of portfolio is associated with high risk tolerance as well as longer time horizon for the need to use the money that has been invested. The second category is associated with the conservative strategy which basically prioritizes risk factors and is therefore risk averse. This kind of portfolio has low risk tolerance and shorter time horizon for the need of the money invested. Conservative portfolios consists mainly of cash and cash equivalents as well as high quality fixed income instruments The third category is the moderate portfolio. This portfolio is centered on the need to protect the value of any investment that is made by an investor or a group against inflation. This portfolio is associated with individuals or investors with longer time horizons in addition to average risk tolerance. They therefore try to balance the risks and returns of an investment. Choosing a portfolio and building a diversified portfolio is dependent on an investor’s financial plan (Andersen, Bollerslev, Diebold & Labys, 2005). The process of diversification of portfolios starts with ensuring that the assets mix in ones portfolio aligns with his or her financial capabilities, risk tolerance and investment time frame. These three factors impacts heavily on the returns one will get from the diversified portfolio. It furthermore requires the understanding of the performance of each asset to know the portion to be allocated to each. The process of choosing or building a portfolio can be divided into four stages. The first step is determining the appropriate asset allocation. This starts with ascertaining ones financial capabilities as well as investment plans. It further takes into consideration factors such as age, time horizon for needing the money as well tolerance of risks. The second step is achieving the portfolio designed in the first step. After deciding on a particular portfolio, the second stage involves deciding how to allocate the capital to the various asset classes in that particular portfolio category. This may involve further dividing the classes into smaller subsections so as to understand them fully and decide on the portion of capital that will be invested in each. The third stage of selecting and building a portfolio is the reassessment of portfolio weightings. This stage is necessary because factors such as financial capabilities and need for money may change with time. This therefore requires reassessing the weightings of the asset classes of a portfolio periodically. The final stage of portfolio construction and development is the strategic rebalancing stage. Once the investor reassesses the weightings of his or her asset classes and determines those that are over weighted or underweighted, strategic rebalancing that involves selling of part of the overweighted assets and buying more of the underweighted class is usually done strategically. However, throughout the process of portfolio development, diversification is necessary to spread the risks Capital Needs of an Investment Every investment needs capital for it to be started. Capital is the money that is required to set up a business. The capital needs of an investment encompass both the initial start up capital and the money needed to keep the business running. The initial startup capital include money to buy assets, infrastructure as well as the money used prior to the start of the business for example money used in getting consultation services and advice from professionals. Capital needs is an important aspect of each business and it too influences the success of a diversified portfolio. A diversified portfolio generally may require more capital as compared to a non-diversified one. This is because a diversified portfolio involves investing in different assets or sectors as a go. Therefore, this requires more capital. During the process of diversification, money that is required to cater for consultancy costs, registration of business as well as setting up the infrastructure makes the capital needs of a diversified portfolio higher than that of a non diversified portfolio. These factors therefore tends to at times limit the level of diversification an investor can attain and also impacts on the choices of assets that he can diversify in. Risks of an Investment The main aim of diversification of portfolios is to ensure distribution of risks across several divides so as to limit the effect when they occur. In order to fully understand how diversification works, it is important to understand what business risks are and the types of risks that are associated with any investment. Risk generally refers to the possibility of a company or an investment recording lower returns or profits than anticipated (Kuritzkes, 2002). This may be due to several factors such as inflation, government regulations, low sales, disasters as well as competition. The outcome of risks is usually low profits and losses to an investor. Therefore, in order to gain valuable returns from an investment, understanding risks and types of risks involved in an investment is paramount. Some of the various types of investment risks are discussed below. Market risks Market risks are risks that are associated with movement of various market factors that include interest rates, the foreign exchange rates, as well as asset prices in the market. These factors may have negative impact on the returns of an investment if the investment is not shielded from them. Credit Risks These are risks that cause losses due to the failure of creditors or obligors to honour their payments. This reduces cash flow in the investment as result in low profits and losses. Business risks These are risks that are usually as a result of the adverse conditions in the revenue of an investment or a business. Business risks are normally caused by factors such as stiff competition or reduction in the demand of a commodity in the market place resulting in reduced levels of revenue. Catastrophe Risks These are risks that are associated with the occurrence of catastrophes Event Risks Event risks are risks that are associated with the occurrence of events such as natural disaster, litigation or a fraud. Political Risks Political risks are associated with the political system of a country. They are risks that occur due to politically motivated events or occurrences such as post election violence, corruption and poor legislations by a dictatorial regime. Various investments are associated with various risks. For example investing in the stock market is usually associated with risks such as changes in the foreign exchange rates as well as political factors that may increase or lower investor confidence in the stock market. When diversification is carried out, the risks associated with each single asset and investment are spread across the entire portfolio. This therefore ensures that when one asset is affected, the rest of the other assets are not affected hence the shock of the risk is absorbed. However, studies have shown that this normally occur only up to a certain level (Hagin, 2004). Furthermore, the risks that are associated with each single asset can at times be reintegrated leading to the overall effect impacting heavily on the entire portfolio. This is normally seen is conglomerates that have heavily diversified portfolios. Tax and Investment Taxes are deductions that are levied on an investment by the national or federal government. Every kind of investment is associated with its own tax implications. Therefore every investor should be able to understand the various tax implications of their investments. Selling of stocks for example has its own implications relating to taxes. When one sells stock, he or she incurs capital gain taxes which are normally calculated according to the duration of time that the stock was held. Dividend contributions, which are taxable payments that a company gives to its shareholders after a certain duration of time, can be taxable or non taxable. The dividends are taxable when they are given in form of cash. However when they are given in form of stocks they are not taxed until the shareholder decides to sell the stock. Mutual funds which include both income dividends and capital gains are also subject to tax. This therefore means that understanding of the tax implication associate with an investment is important. Understanding tax implications of an investment helps an investor to get to know the potential tax advantages that he or she may exploit to maximize returns on an investment. Furthermore it helps the investor to determine when and how he or she can carry out the investment with minimal taxes. Diversification of portfolios exploits the various tax advantages associated with different assets or investments so as to maximize the returns. Diversification reduces tax liabilities of an investment. The progressive nature of taxes enables diversified portfolios to reduce tax liabilities through the reduction of income volatility. This therefore increases the returns of an investment. Tax implications therefore determine the kind of investments or assets an investor picks to put money on. This is because the returns on an investment will be affected by the tax implication on that investment. Assets that usually attract high tax implications will mostly be avoided because of the expected low returns. However, diversification has been proven to help counter the impact of taxes on the investment by spreading the impact of taxes across the portfolio just as risks are spread when diversification is done (Schinasi, & Smith, 2007). Choosing the Right Product and Company to Invest in Choice of a wrong product or company to invest in can result in losses or low returns. This therefore requires an investor to weigh his or her options when choosing a product to invest in. Making a wrong choice on products and companies to invests in leads to losses on investment (Sadgrove, 2005). The first step that is involved in determining the product or company to invest in according to Sadgrove, (2005) is staying within your area of expertise. When one invests in an area where he or she is competent in, the likelihood of the returns on the investment being maximized is high. This therefore means that when one is an expert in retail business, he may consider investing in retail chains such as Walmatt as he will be well versed with that line of business. The other step or strategy in choosing a product or company to invest in is through the use of moats. Economic moats are those companies that have maintained virtual monopoly for a long time and hence have competitive advantage over their competitor. When choosing a company or product to invest in, it is also important to check on the quality of the management as in most cases this will show an investor the competence of the management when dealing with employer, customer as well as the investors. Discussion Various factors have been found to determine the success of an investment or its failure. Taxes, capital, portfolio, risks and the product or company one invests in, have all been found to affect the returns of an investment. Diversification however limits the effect of number of these factors on the returns of an investment. Risks that are spread across different portfolios reduce the effect of a single catastrophe on an investment. Through proper understanding of taxes and tax implications, an investor can make use of the various tax advantages through diversification in order to increase the returns of the investment. Choosing the right portfolio to invest in however is a task that might require extra capital and professional advice. Advice on tax implication, market trends as well as government regulations need to be sought from an expatriate before settling on a portfolio. Conclusion Construction of a diversified portfolio associated with defensive risks profile is therefore an investment strategy that increases the returns on an investment. This is especially through spreading out of risks across different assets and reduction of expected tax liabilities. This strategy is therefore suitable for various kinds of investments and it will lead to increased returns. References Andersen, T, Bollerslev, F, Diebold, X. & Labys, P. (2001). The Distribution of Realized Exchange Rate Volatility. Journal of the American Statistical Association, 96, 42-55. Garcia, P. (2006). The Best Investment for your Investment Portfolio. Washington DC: Greenwood Publishers. Graham, K. (2010).Diversification Strategy: How to Grow a Business by Diversification Successfully. London: Kogan Page Ltd Hagin, R. (2004).Investment Management: Portfolio Diversification, Risks and Timing-Facts and Fiction. Denver: John Wiley & Sons, Inc Kuritzkes, A. (2002). Operational Risk Capital: A Problem of Definition. Journal of Risk Finance, 4 (1), 47-56. Sadgrove, K. (2005). The Complete Guide to Business Risks Management. Burlington: Gower Publishing Company Schinasi, G & Smith, R. (2007).Portfolio Diversification, Leverage & Financial Contagion.IMF Working Paper Siegel, J & Shim, J. (2005).Accounting Handbook. New York: Baron Educational Series, Inc Read More