Diversification in Financial Markets - Essay Example

?Diversification in financial markets Diversification in financial markets Diversification in financial markets should be approached with a lot of caution. The investor should do an analysis of the different portfolio options and their profitability in the preceding years. Data for such investments and markets is available through brokers, online service providers and governmental institutions. Only portfolios that have been generating profits previously should be considered. The behavior of each of the specific markets and instruments over time should also be analyzed extremely well. Some markets can be stable with a clear direction while others move up and down without any clear direction. Such markets are said to be volatile and investing in them can be extremely risky. A lot of volatility increases the chances of losing especially if the capital is not large enough to caution the investment from the volatility (Smith and Schinasi, 1999). Allocating Capital The amount of money to invest in each of the markets or instruments solely depends on the investor. There is a percentage of risk the investor is comfortable investing in each of the chosen portfolios. This should also work together with the behavior of the markets in the last few months or years. An investor can invest more percentage of the capital in stable markets and instruments as there is little or no risk. Volatile and unstable markets should only be allocated a small percentage of the capital. In fact, investors should avoid trading volatile markets. If all the markets of interest are very volatile, the investor should consider waiting for volatility to come down before investing. Diversification in the financial markets has many advantages, including; Guaranteed profits: diversification in financial markets almost guarantees profitability. This is because even in the worst-case scenario, some of the markets and instruments will generate profits. If the investor has invested in five different options, it would be possible to have some in profits and some into losses. It is rare to have all the investments in losses as well as profits. Trading financial markets is online nowadays making it easy to monitor the price action movements anytime, all the time. Any changes in the market can be seen by the investor immediately and perform the necessary action in good time. If the markets were going against the investors bet, they can close the positions at once and remain with little or no losses. With good money management skills, even the others should be able to generate profits after some time. The charges for trading in the various markets are relatively low compared to other types of investments. With that, most of the profits made are retained by the investor (Caruso, Silli, and Umlauft, 2005). Reduced Risk: investing in different portfolios reduces the risk exposure of the capital. As such, it would be hard to lose all the capital. Even if some of the portfolios go at a loss, the investor will be guaranteed that at least some of the portfolios are into profits. In some cases, investors can even hedge, in which case they can make profits in one market while another is negative (Madura, 2012). Leverage: some financial markets institutions work with margin trading. Investors are required to raise a certain proportion or percentage, and the broker tops it up allowing the investor to purchase more units than they would have purchased with their own money. Leverage can increase the profitability factor of an investment but can also lead to substantial losses. Diversification and leverage would allow the investor to venture into different markets and invest in many different investments with little capital (Gilchrist, 2003). Management of Capital: Diversification in financial markets allows easy management and preservation of capital. Investors have access to a variety of tools and software that assists them in determining how they are going to invest, the amount of investments to make on what elements and calculations of the risk to reward ratio. This is important as it ensures that the clients profit and manage their profits and capital accordingly. Investors may be able to salvage part of the capital in the event of random and rapid changes in the markets. This would allow investors to invest when markets have stabilized or in another sectors of the economy(Frontier Investment Management, 2007). Using online software by financial market trading providers can make it possible to dictate the highest amount an investor would like to lose in the case markets go against his bet, and the amount the investor would like to make when the markets are along the bet. This makes it possible for investor to do other things while markets are moving and their capital being managed accordingly (Frontier Investment Management, 2007). Availability of market information and data: a lot of information on the trend and the behavior of markets is always available through independent market analysts as well as financial institutions. Data is available on a daily basis and updated regularly making it possible to have suggestions on what markets to invest in, sell, hold and/or plan to invest in. The Intenet has made it possible to access this important information in real time and making orders, betting and closing positions in real time. All an investor need is a portable computer or the Internet enabled smart phone or tablet. The Internet has made it possible for even people who do not have financial market knowledge to invest in these markets and profit (Accomazzo and Rivadeneyra, 2009). Limitation of Diversification Diversification of portfolio in the financial market is also risky. There are cases where all markets are affected and vulnerable to collapse. Credit crunch which is basically banks reducing exposure to risk by hoarding their liquidity can greatly affect the various markets. Banks have a pivotal role in financial markets, and this action will affect the functions of the financial markets directly. Bankruptcy and crises in banks can also lead to increased exposure to financial markets. For example, the banking crisis of 2008 brought some markets to their knees literally (Rioja, Rios Avila, and Valev, 2012). The individual jurisdictions can also affect the markets. United States, for example, has a large debt burden. This affects public spending and could influence the investors’ sentiments on the various markets in the United States which can lead to deterioration in those investments. Regional concerns, for example, the economic woes in Europe also have a great impact on the financial markets. Such concerns influence sentiments, demand and supply leading to low profitability and even losses (Auernheimer, 2010). It is also important for investors to know that there are impromptu activities that can have severe effects on markets. The September 11th, 2001 attack on the United States led to low confidence of investors. They could not buy American stocks, and some traders bet against the American currency as well as stocks. This sent shock waves to the various sectors of the American Economy and investments, and some investors lost their capital. Investors should therefore be aware of such scenarios, and acknowledge that they can happen anywhere in the future, in which case, all the capital invested in the different markets will be susceptible to loss (Yavas, 2007). Conclusion Financial markets are some of the most profitable ventures in the world today. The best and safest way of investing in financial markets is diversification. The profitability in the financial markets can be very high. However, economic woes and financial institutions’ and specific countries’ problems can affect the financial markets leading to potential losses. Diversification in financial markets should therefore be approached with care to work perfectly well. Relying on experienced experts and the general investment sentiments on the various markets may also affect the profitability. Investors in financial markets should know that the markets are risky despite the high profitability potential. References Accomazzo, D and Rivadeneyra, R. 2009. An Alternative Way to Manage Equity Portfolios: Active alpha portfolio management with exchange-traded funds: a simple strategy for the future. Graziadio Business Review, 12 (1). Auernheimer, L. 2010. International Financial Markets: The Challenge of Globalization. Chicago: University of Chicago Press. Caruso, M., Silli, B and Umlauft, R. 2005. The benefit of emerging market diversification in Practice: Institution Vs Private Investors. [online] Available at: [Accessed 21 October 2013]. Frontier Investment Management. 2007. The Benefits of Portfolio Diversification. [online] Frontier Investment Management. Available at: [Accessed 21 October 2013]. Gilchrist, 2003. Financial Markets and Financial Leverage in a Two-country World-economy. Santiago: Banco Central de Chile. Madura, J. 2012. Financial Markets and Institutions. Stamford: Cengage Learning. Smith, T and Schinasi, G. 1999. Portfolio Diversification Leverage and Financial Contagion. Washington D.C: International Monetary Fund. Rioja, F., Rios Avila, F., and Valev, N. 2012. The Persistent Effect of Banking Crises on Investment and the Role of Financial Markets. [online] Available at: [Accessed 21 October 2013]. Yavas, B. 2007. Benefits of International Portfolio Diversification: Findings indicate that co-movements among the U.S., Germany, and Japan markets are significant.. Graziadio Business Review. 10 (1). Read More