Portfolio diversification beyond stocks can be one of the most important determinants of your stock trading record. Efficient portfolio diversification is an essential element of the investment management process. In simple terms, to form a diversified portfolio you need, to include in your investments portfolio, assets that do not co-move a lot. Generally, a portfolio consisting of 20 stocks can be considered as fairly diversified. However, if you want a really efficient diversified portfolio you should consider diversification beyond stocks.
Strictly speaking, if you want to hold a really diversified portfolio you must consider diversification beyond stocks. The reason is that during bear markets, the co-movement (correlation) of stocks increases dramatically. It doesn’t really matter if you have chosen stocks from different industries or sectors. It doesn’t really matter if you have chosen low beta or defensive stocks as well. Bear markets are, most of the times, very volatile, and panic takes over driving down the prices of even the most valuable stocks. Bonds, and more particularly AAA (“triple A”, investment grade) or government bonds turn out to be extremely valuable during bad times. The reality is that stocks and bonds are the most popular “assets” among investors. However, in present days many portfolios are diversified beyond stocks and bonds and are tilted to more exotic investments, such as precious metals, other commodities, mutual funds, ETFs, RAITs and other.
Bonds: Bonds are more safer than stocks because coupon and principal payments are predetermined and scheduled. On the contrary, stock dividend payments and capital gains (from stock trading) are neither scheduled nor certain. They very uncertain in fact! It is true that high grade bonds are more safe than stocks if you plan to hold the bond until the maturity date. However if you plan to sell a bond before its maturity you should keep in mind that bond prices vary a lot because of interest rate variation and shifts in demand and supply. In the case of bonds, diversification beyond stocks, can be accomplished by holding a variety of U.S. and non-domestic government and corporate bonds. Stock traders and investors concerned about inflation should choose short-term bonds which are less sensitive to interest rate changes. Inflation indexed bonds are a good hedge against inflation risk.
REITs: Real Estate Investment Trusts (REITs) can generate a significant flow of income and can be used in a diversification beyond stocks plan. Keep in mind that mortgage REITs can be very sensitive to interest rate changes and that are more correlated with stocks than bonds are. Moreover, if you own a house or two, you are already significantly invested in real estate and you should not increase your exposure further. In the case you want to increase your exposure further, you should prefer REITs focused on commercial real estate rather than residential real estate.
Precious Metals: Generally, gold’s price changes have been negatively correlated with stock markets over time. The demand for gold and other precious metals significantly increases during turbulent times and bear markets. It seems that investors consider precious metals as a safe asset, alternative to AAA (prime) government bonds. However, gold’s price may be very volatile in the short term, increasing your portfolio’s overall volatility. Retail investors can diversify beyond stocks using Mutual Funds and Exchange Traded Funds (ETFs) specialized in precious metals.
Whether you are a short-term, high-frequency stock trader or a long-term buy-and-hold investor you have to understand the benefits of portfolio diversification beyond stocks. Bear markets can last long and periods of excess volatility can dramatically affect your stock trading performance. At the end of the day, your ultimate goal is to protect your investment capital, remain in the stock trading business, and benefit from anticipated trends in stock markets.
StockTradingCollege.com, Stock Trading and Investing for Beginners
Strictly speaking, if you want to hold a really diversified portfolio you must consider diversification beyond stocks. The reason is that during bear markets, the co-movement (correlation) of stocks increases dramatically. It doesn’t really matter if you have chosen stocks from different industries or sectors. It doesn’t really matter if you have chosen low beta or defensive stocks as well. Bear markets are, most of the times, very volatile, and panic takes over driving down the prices of even the most valuable stocks. Bonds, and more particularly AAA (“triple A”, investment grade) or government bonds turn out to be extremely valuable during bad times. The reality is that stocks and bonds are the most popular “assets” among investors. However, in present days many portfolios are diversified beyond stocks and bonds and are tilted to more exotic investments, such as precious metals, other commodities, mutual funds, ETFs, RAITs and other.
Bonds: Bonds are more safer than stocks because coupon and principal payments are predetermined and scheduled. On the contrary, stock dividend payments and capital gains (from stock trading) are neither scheduled nor certain. They very uncertain in fact! It is true that high grade bonds are more safe than stocks if you plan to hold the bond until the maturity date. However if you plan to sell a bond before its maturity you should keep in mind that bond prices vary a lot because of interest rate variation and shifts in demand and supply. In the case of bonds, diversification beyond stocks, can be accomplished by holding a variety of U.S. and non-domestic government and corporate bonds. Stock traders and investors concerned about inflation should choose short-term bonds which are less sensitive to interest rate changes. Inflation indexed bonds are a good hedge against inflation risk.
REITs: Real Estate Investment Trusts (REITs) can generate a significant flow of income and can be used in a diversification beyond stocks plan. Keep in mind that mortgage REITs can be very sensitive to interest rate changes and that are more correlated with stocks than bonds are. Moreover, if you own a house or two, you are already significantly invested in real estate and you should not increase your exposure further. In the case you want to increase your exposure further, you should prefer REITs focused on commercial real estate rather than residential real estate.
Precious Metals: Generally, gold’s price changes have been negatively correlated with stock markets over time. The demand for gold and other precious metals significantly increases during turbulent times and bear markets. It seems that investors consider precious metals as a safe asset, alternative to AAA (prime) government bonds. However, gold’s price may be very volatile in the short term, increasing your portfolio’s overall volatility. Retail investors can diversify beyond stocks using Mutual Funds and Exchange Traded Funds (ETFs) specialized in precious metals.
Whether you are a short-term, high-frequency stock trader or a long-term buy-and-hold investor you have to understand the benefits of portfolio diversification beyond stocks. Bear markets can last long and periods of excess volatility can dramatically affect your stock trading performance. At the end of the day, your ultimate goal is to protect your investment capital, remain in the stock trading business, and benefit from anticipated trends in stock markets.
StockTradingCollege.com, Stock Trading and Investing for Beginners