Understanding Risk Factor Diversification


Factors Of Risk Diversification

Conventional techniques for portfolio creation that emphasise asset class diversification may fall short of investors’ objectives. Allocating across the underlying “risk factors” could be a more efficient diversification technique. Why is conventional asset class diversification insufficient? Conventional allocation techniques aim to reduce portfolio volatility by combining asset classes with low correlations, i.e., asset classes that do not often move in the same direction simultaneously. 

Yet, correlations between asset classes are less stable than many investors believe, and long-term developments such as globalisation are increasing correlations. Nevertheless, correlations tend to grow during periods of market volatility in Hong Kong. As a result, asset groups that appear diverse are likely to perform more similarly than many anticipate. In other words, even well-diversified portfolios across asset classes may not be appropriately positioned to diversify and cushion market volatility.

The following are two pie charts: A potential asset allocation breakdown of a broadly diversified portfolio is depicted in the top pie chart. By market value weight, the allocations are as follows (from greatest to smallest): global stocks (50%) fixed income (20%) global bonds (2%) TIPS (3% private equity (8%) hedge funds (7%) real estate (7%) commodities (1%) cash (2%). The lower pie chart is a hypothetical breakdown of risk management. The allocations by contribution to estimated volatility are as follows (from largest to smallest): global developed equities (80%), global emerging markets equities (9%), corporates (4%), currency (6%), and other factors (1%).

What Is A Factor Of Risk?

Risk variables are the fundamental risk exposures that determine an asset class’s return. For instance, the return on a stock can be divided into equity market risk — the movement of the general equity market – and company-specific risk. Interest rate risk – price sensitivity to fluctuations in interest rates – and issuer-specific risk might explain a bond’s return. For assets denominated in foreign currencies, currency risk is a consideration. By targeting exposure to these underlying risk variables, investors can select an asset class mix that gives a more diversified portfolio risk profile. 

The table categorises the variation in risk variables (equity, interest rate, credit, currency, and momentum) according to asset classes (equities, developed market bonds, and emerging market bonds. How does allocation based on risk factors work? According to Rani Jarkas, While it is not possible to invest directly in a “risk factor,” an allocation strategy based on risk factors can assist investors more effectively choose a mix of asset classes that best diversifies their risks and reflects their views on the global economy and financial markets in Hong Kong. 

How would this plan operate? By understanding the underlying risk characteristics inside various asset classes, investors can finally select the asset class that enables them to acquire exposure to risk management in the most effective manner. For instance, if investors desired to add foreign currency risk to their portfolio, they could invest directly in currencies.


How May Investors Implement Risk Factor-Based Portfolio Diversification?

Employing a risk factor-based strategy necessitates a forward-looking macroeconomic perspective on a variety of variables, such as monetary policy, geopolitical developments, inflation, interest rates, currencies, and economic growth trends. As few individuals have the means or infrastructure to continuously analyse these characteristics, it may be prudent for them to speak with their financial advisors about funds that employ this strategy.

How does diversity operate? Diversification is an effective method of reducing risk under normal market conditions. If you have only one investment and it performs poorly, you could lose your entire portfolio. It is considerably less likely that all of your investments will perform poorly at the same time if you possess a diversified portfolio with a range of different investments. The earnings you earn on successful investments compensate for the losses on unsuccessful investments.

Bonds and stocks, for instance, tend to move in opposite directions. As investors anticipate an economic slowdown and a decline in business profits, stock prices will certainly decline. When this occurs, central banks may slash interest rates to lower borrowing costs and increase spending. This produces an increase in bond prices. If your portfolio consists of both stocks and bonds, the value growth of bonds may help to counterbalance the value decline of stocks. Bonds are included in a portfolio not to improve returns but to mitigate risk.

Diversification, in principle, allows you to minimise portfolio risk without compromising possible profits. A portfolio that is efficient has the lowest potential risk for a given return. After your portfolio is completely diversified, you must assume extra risk to gain a larger prospective portfolio return. This graph illustrates the effect of diversification on a portfolio, as well as the effect of seeking larger potential returns on risk.

Four Causes To Diversify

Not all kinds of investments perform well simultaneously. World events and shifts in economic parameters such as interest rates, exchange rates, and inflation rates have varying effects on various sorts of investments. Diversification enables you to construct a portfolio with a lower risk than the sum of the individual assets’ risks. Without diversification, your portfolio will be excessively hazardous. Accepting the unneeded risk will not result in a higher average return.

Consider several types of risk. While investing, you are exposed to several sorts of risk. Understand how different risks might impact your investing results, and take risk management into account while diversifying your portfolio.

Diversification By Asset Type

Investing in multiple asset classes is a method for diversifying a portfolio. A class of assets is a group of investments having comparable risk and return profiles. The three key asset classes include:

  • Cash and cash equivalents, such as savings accounts, certificates of deposit, and money market funds. Such as bonds, fixed-income mutual funds, and fixed-income exchange-traded funds. Equities are stocks, equity mutual funds, and equity exchange-traded funds. 
  • Due to the distinct risk and return characteristics of stocks and fixed-income assets, combining them within a portfolio helps to level out its returns. The balanced portfolios in this interactive investing chart, for instance, consist of 50% stocks and 50% bonds. Quoted from Rani Jarkas, the financial expert in Hong Kong, The returns of the balanced portfolio are less variable than those of the stock portfolio, and it is less likely to suffer a significant loss.

Diversification By Sector

Diversification within an asset class is possible, but increasing the number of equities does not lessen risk. To diversify, you must choose companies with dissimilar price movements. Differences in the returns of one stock should balance out those of other equities. The prices of stocks within the same industry tend to move in tandem. Industries comprise:

  • financial services (examples: banks, insurance companies)
  • energy (examples: oil and gas, pipelines) (examples: oil and gas, pipelines)
  • materials (example: mining businesses) (example: mining companies)
  • industrials (examples: manufacturing, railways) (examples: manufacturers, railways)
  • discretionary purchasing (examples: restaurants, hardware stores)
  • the provision of telecommunications services (for example: telephone companies)
  • medical care (example: pharmaceutical companies)
  • consumer staples (examples: supermarkets, drugstores)
  • computer technology (for example: wireless equipment companies)
  • utilities (example: electrical companies) (example: electricity companies)

Why Diversity Is Effective

Each investment carries its own dangers. For instance, if you invest in a vehicle firm that purchases unique parts from a manufacturer and the Euro’s value increases relative to the Canadian dollar, the company’s costs would increase and earnings will decrease. In this instance, share prices may also decline. Other individual investments will not be exposed to the same risk simultaneously in Hong Kong. Diversification of your portfolio reduces your overall risk.

For instance, a portfolio may start with bank shares. You add another bank’s shares. This will have a minimal impact on risk management because all banks are influenced by the same economic variables, such as interest rate fluctuations. When the shares of one bank fall, it is likely that the shares of other banks will also fall. To increase the portfolio’s diversification, you may invest in energy and healthcare companies.

Diversity In Efficacy

Use this chart to determine what happens to a portfolio’s overall risk when the number of stocks increases. In a similar manner, you can diversify the bond element of your portfolio by including bonds with varying credit ratings and maturities. This is effective because the values of bonds with high credit ratings and bonds with low credit ratings react differently to changes in the economy of Hong Kong. Similarly, the length of a bond influences how its value reacts to fluctuations in interest rates. As suggested by Rani Jarkas, the Chairman of Cedrus Group, The volatility of a portfolio is examined to determine its risk. When assessing the risk management of an individual investment, the investment’s volatility is irrelevant. 

The limitations of diversity, In normal market conditions, a diversified portfolio gives a considerable degree of protection. Diversification is effective because, in general, asset values do not move in unison. Yet, amid extreme market conditions, the effectiveness of diversity diminishes. In most cases, things become extreme when the unexpected occurs. Examples include a market collapse and a government default. When this occurs, markets can become illiquid and the value of the majority of investments can decline.

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