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Investment diversification by design to mitigate impact of market storms

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It’s been a rough winter and early spring. A series of Nor’easters brought high winds, tree damage and downed power lines.

A loss of electricity means no heat either, right? Well, not exactly.

We have diversified sources of heat. People have added propane fireplaces, wood stoves and gas generators to power space heaters.

Diversification has made the end goal of obtaining heat possible from a variety of mutual sources.

Those who had a variety of heat sources avoided feeling cold and uncomfortable – much like diversification in markets can help avoid feeling uncomfortable about your investment portfolio.

SMOOTH OUT EVENTS

What is investment diversification and how is it associated with risk management and portfolio design?

A broad definition starts with diversification as a risk management technique used to build a portfolio, which is comprised of a wide variety of investments. These investments come from many sectors and include stocks, bonds, mutual funds, cash equivalents and exchange traded funds.

Diversification strives to smooth out events, allowing the positive performance of some investments to neutralize the negative performance of others.

A diversified portfolio also should be balanced between asset categories since segments of each category may perform differently under the same market conditions.

ASSET ALLOCATION

Components of diversification include identifying a proper asset allocation, risk level and expected returns.

Asset allocation is often defined as an investment strategy that balances risk and reward by apportioning a portfolio’s assets according to an individual’s goals and risk tolerance, given the investment time horizon. Objectives are balanced by using ratios, which pertain to the underlying classification of holdings.

Many asset allocation models suggest the inclusion of global diversification, especially as more international economies become stabilized and qualify to participate.

As a risk offset, bad news for domestic markets may be good news abroad. Investors may be positioned to capture returns based on overall participation in multiple markets.

RISK

When considering investment risk, we face the probability of losses relative to expected returns. The reward for taking on risk is the potential for greater gains.

The level of uncertainty one faces in achieving the returns provides an opportunity to evaluate time frames.

Diversification enters the picture when we consider the financial goals with long- versus short-term durations.

A longer term would be required for a more heavily weighted equity portfolio, while a shorter term using less risk leans toward cash equivalents and bonds.

IDENTIFYING THE DIMENSIONS

When considering the added element of expected returns, additional premiums are captured. This does not involve predicting which stocks, bonds or market areas are going to outperform in the future but focuses on design.

The goal is to hold a well-diversified portfolio that emphasizes dimensions of higher expected returns with low turnover.

University of Chicago professor and 2013 Nobel Laureate Eugene Fama has contributed to identifying these dimensions.

His hypothesis, “Efficient Capital Markets: A Review of Theory and Empirical Work,” showed that current prices incorporate all available information and expectations into securities prices.

VAST AMOUNT OF INFO

In the academic research of equity markets, the dimensions demonstrated are size (small cap versus large cap), relative price (value versus growth) and expected profitability (high versus low). In the fixed income market, these dimensions are term and credit quality.

The markets aggregate a vast amount of dispersed information and drive it into security prices.

By observing a well-diversified approach, disciplined risk-managed strategies and a focus on dimensions of expected returns, one may be better prepared for the next Nor’easter.

Jeffrey C. Deloglos is trust officer at ESSA Bank & Trust, Hanover Township, Northampton County. He can be reached at jdeloglo@essabank.com.

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