Myths about diversification Part 2

Important questions to ask when someone yells “diversification!”

What are the metrics of diversification that really matter?

• Credit or Default Risk: Default risk is the chance that the issuer of the bond you purchased will not repay your principal or interest (in full) at the due date. One measure of this risk is a “Credit rating”. Diversifying your portfolio according to credit risk is one of the simplest ways of applying the concept of diversification. Investors often try to diversify their investments along this metric, so that if one company defaults, the impact on your portfolio is limited. Diversifying “default risk” is always a basic and useful starting point. For starters, you can ask your investment advisor – what is the likelihood that this company or Government will repay me my money? Ask them to give you a real-life example to make it clear. For example, Apple issued some bonds last week with coupons between 0.6% and 2.8%. That is an indication of what you earn in low-risk A- rated companies. However, UBER bonds will pay you coupons of 6.25% or 7.5% because it is high risk and CCC+ rated. Think of a credit rating like a grade in school. Anything BBB and higher is considered relatively lower risk and anything below, relatively higher risk. Like many things in life, risk exists on a spectrum. Asking for context on either end of the spectrum will help you find a happy place within.

• Geography: While many people believe that they need to diversify their portfolio across different countries, this can become increasingly difficult and complex. With an increasingly inter-connected and globalized world, it is unlikely that a crisis in one region will leave the rest of the global market untouched. Instead, we suggest that investors view their portfolios according to “developed markets” and “emerging markets”. In theory and in practice – emerging market investments are usually characterized by higher risk levels than developed markets. However, there are some emerging market stocks or bonds that could be considered safer than some high risk developed market assets. First and foremost, an investor’s geographical diversification should reflect their risk profile. If an investor has a low risk tolerance, then it follows that their investment portfolio would be concentrated in low-risk regions OR “developed markets” (think the U.S., Germany, the U.K.). Emerging markets offer investors higher returns with higher risk levels – think Brazil, India, South Africa, Jamaica. For the sake of simplicity – it's best to consider your exposure along the lines of “developed markets” and “emerging markets”. If you are risk averse you need proportionately more exposure to developed markets. If you are seeking aggressive growth and can take on more risk – you can take on proportionately more exposure to emerging markets. 

• Asset class: An age old, universal question – how much of my portfolio should I spread across different asset classes? What proportion should I hold in equities versus bonds versus real estate versus pooled products such as mutual funds or unit trusts? The easy answer is that it all depends on your objectives and risk profile. But the hard and more realistic answer is that even with clarity on your risk and objectives, it is still a nuanced decision worthy of a separate article. We will address that quandary in our third and final piece on diversification.

Marian Ross is Vice President, Trading & Investment at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm

Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm