How To Create A Balanced Investment Portfolio
Portfolio diversification is an investment strategy used to spread risk across a number of asset classes. Rebalancing your portfolio is one of the critical factors necessary in securing successful investments over a long-term period. This article will discuss several ways to minimise the risk from your investments.
Rebalancing in its raw form means adjusting your holdings in different ways. It can be achieved by buying and selling certain funds, currency pairs, stocks, ETFs, or other securities in order to maintain your established asset allocation. Choosing the right asset allocation will probably be one of the most critical investment decisions you'll ever make. Let's say you hold all of your investments in similar securities with your local currency in products such as bonds and stocks. Your portfolio returns will reflect those two markets. Nonetheless, should both markets experience a downturn, so will your asset values as well.
One mechanism for further diversification is via currency diversification. Let's say a portion of your portfolio was invested in assets denominated in a foreign currency, such as the Japanese yen. In this case, the returns from the Japanese currency and the asset relative to your local currency could have offset some of the portfolio losses in your local assets.
Basically, when its a risk-on environment, the prices of commodities tend to increase, and traders will usually buy the Australian Dollar (AUD). When commodity prices go up, stock markets go up as well, creating a demand for positive swaps on AUD pairs, such as AUDJPY and AUDCAD, as opposed to the Japanese yen (JPY). When it's a risk-off environment, usually the opposite occurs; as a result, the JPY appreciates, as foreign flows from Japan are repatriated back to their local currency.
Let us have a look at an example of the yen's strength. This is what usually happens:
- 100% risk-off sentiment
- Gold goes up
- Commodity prices go down
- Equities go down
- The yen strengthens as a result
Since the Japanese can get cheap credit, they tend to invest heavily overseas. When the risk sentiment is on, they bring the money back, creating a demand for the yen; and vice versa, when equities are bullish, the Japanese pump their money overseas, selling yen and purchasing foreign currency.
Traditional Portfolio Diversification
Investors tend to hold a combination of equities and bonds as part of a diversified portfolio. Debt instruments normally continue paying interest during a downturn, whilst equities often depreciate in a slowing economy. Consider it a feng shui for your investments. This strategy can be tested during economic downturns and inflation, often known as the stagflation scenario. As this often erodes the value of a currency, the interest from bonds may not compensate for the losses in equity investments. In addition, real estate investments are not fool-proof either: one example is the subprime mortgage losses that occurred in the US markets during the last global financial crisis in 2008.
Adding A Foreign Currency To The Portfolio
Investing in foreign currency denominated assets might be worth looking into, due to lower costs and accessibility of the foreign markets in modern times. Investments in various currencies could be added to a profitable portfolio for diversification purposes. For example, if we invested some funds into real estate within the U.S, and borrowed at low interest rates, the remaining cash could be invested into a different currency, perhaps one yielding a higher interest rate. It's important to note that currency strength is often associated with a strong balance of trade and strong economic activity.
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Which Currencies Should Be Considered?
This is important for diversification and portfolio risk: as Swiss and Japanese interest rates are negative, it would make much sense to hold Yen and Franc balances. An investor may convert some of these currencies for higher yielding currencies like the New Zealand Dollar (NZD). In addition, allocating a part of the portfolio to a commodity currency could be partially effective to hedge inflation risk. This could be a commodity currency from a country such as Canada for exporting its oil, or a gold exporting nation like Australia.
The main commodity currencies are the Australia, Canada and New Zealand Dollars, which have all experienced healthy growth while the economies of Japan, Europe and the United States have been sluggish. Furthermore, while inflation reduces the purchasing power of money, a carefully selected currency position in the investment portfolio could be a more profitable option in the long-term.
The inflation is also an important factor when selecting which equities to invest in. You might be asking why? The answer is simple - for equities to climb higher. Basically, when there is inflation, it usually means that goods and services are being priced higher. That, in turn, creates more revenue for companies, but on the flip-side, it can mean more costs for companies as well.
Investors should be paying attention to 'stress tests'. A stress test, in financial terminology, is an analysis or a simulation designed to determine the ability of a financial instrument or financial institution to deal with an economic crisis. It is connected to equities, as it affects bank shares. Banks keep the capital for three main risks:
- Operational Risk
Operational Risk uses the so-called 'Basel' standards to classify certain operational risk types, and uses historical operational loss events from the bank together with external databases to determine major risk events.
- Market Risk
Market Risk uses a statistic called 'Value at Risk' (VAR) for all market positions that the bank holds, usually in bonds and credit derivatives.
- Credit Risk
Credit Risk is the biggest risk, and holds the most capital, as it relates to the credit that banks lend to counter-parties or customers. It's calculated using 'Customer Credit' ratings. Credit & Market risks are calculated, whereas operational risk is a subjective evaluation, based on prior operational losses and external events.
Regulators use a top-down approach and dictate how much capital is required, rather than banks calculating it themselves through their own risk departments; in addition, risk departments are not tied to the business side of the bank. Regulators are also conservative in nature, it's in their interest to keep the banking industry healthy, so usually they request more capital. This typically affects the equity value of banks.
According to the stress test that was conducted in 2014 by Forbes, the allocation between stocks and bonds affects returns and risk more than any other asset allocation decision. The example chart (see below) from 'Vanguard's Framework for Constructing Diversified Portfolios' shows both the volatility and returns increase as a portfolio increases its exposure to equities.
Source: Forbes - Portfolio Allocation
Below are three investment portfolio strategies and portfolio ideas you might want to consider:
Effective Strategy 1: Split Your Share Portfolio Across Different Sectors
Typical sectors where you as an investor might want to consider moving towards are gold and iron, as well as, banks, energy (gas and oil), telecommunications, and technology. Splitting your share portfolio across different sectors can help balance the ups and downs across all of these sectors that you may experience over time, along with their possible impact on your portfolio.
Effective Strategy 2: Risk Diversified Investing Portfolio
Higher risk companies can usually bring greater value to your portfolio. They have their share price volatility, and might be profitable investments, but should also be balanced with lower risk companies such as blue-chips. Blue chip companies with little or no debt at all and steady revenue inflows are usually considered lower risk, and more likely to pay regular dividends.
Effective Strategy 3: Index Funds
This is considered to be the beginner's investing portfolio. An index fund represents a collection of different stocks or bonds that aim to mirror a specific portion of the market. They can be a good addition to your portfolio in terms of balancing, because they have specific expense ratios (or low fees), coupled with the fact that they attempt to mirror the market. This should mean higher returns over a long-term period.
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This material does not contain, and should not be construed as containing, investment advice or an investment recommendation or, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not reliable indicator for any current or future performance as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisor to ensure you understand the risks.