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How to effectively diversify your portfolio

TradingPub Admin | December 4, 2012

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Want to beat the asset markets by actively trading securities? Try diversification.

Portfolio diversification is fairly run of the mill for experienced investors. The basic idea is that a person can help mitigate risk by not putting all his eggs into one basket. Including more than one asset class can help reduce the chances of incurring a large loss.

Financial experts refer to this as the only "free lunch" on Wall Street, according to a recent Forbes article. This makes sense, as diversification is a tactic everyone can use to lower the overall risk of their portfolio.

Correlations 

The idea behind diversification in a portfolio is selecting assets that ideally have as little correlation with each other as possible, meaning their prices do not move in tandem. While it may sound easy in theory, it is not always simple in practice.

Correlations frequently surge during times of economic turmoil. These relationships between assets were particularly high after the financial crisis, and also during 2011 when markets were spooked by the looming U.S. national debt crisis.

In times like these, widespread panic selling pushes down the value of all assets simultaneously. This leads to plunging security prices and also high correlations.

Diversification Strategies 

Regardless of how high correlations are, there are always strategies investors can use to diversify. According to Forbes, a portfolio that is well-diversified will contain investments from multiple asset classes. Doing so reduces the overall risk of the portfolio and can also boost returns over time.

If an investor follows this strategy and selects several types of assets for his portfolio, it increases the chances that at least one investment will do well, even if others prove to be sinking ships. For example, Treasury bonds surged in 2008 while stocks and commodities plunged as investors fled riskier assets. Investors who combined these debt-based financial instruments with stocks and commodities experienced a lower loss to their entire portfolio and reduced volatility.

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