Build a Diversified Portfolio

As old saying goes "never put all your eggs in one basket", investors should construct a diversified investment portfolio to reduce risks because .....

YT Kum, CFA 04 April, 2007 | 0:00
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As old saying goes "never put all your eggs in one basket", investors should construct a diversified investment portfolio to reduce risks because different stocks rise and fall independently of each other.

In general, regional funds (or funds investing in several countries, like BRIC) are more diversified than single country funds in light of their geographical diversification mechanism, presuming that those countries in the region have dissimilar risk factors. However, there are two traps.

The first trap is that investing in countries with similar risk factors cannot help to construct a diversified portfolio. Diversification works when holdings in some countries in the portfolio rise and fall independent

ly of others in the portfolio, as they are negatively correlated. However if all stocks in the portfolio are positively correlated, they will fall or rise on same factors and hence geographically diversification does not mean risk diversification.

The second trap is that if you hold a regional fund as well as a sector fund focusing on that region, you may have some overlapped holdings in a particular sector, and hence the risk could be increased due to overexposure to that sector or even a particular stock.

For a single portfolio, investors may check the total number of holdings and the weightings of the top 10 holdings to peek at how diversified the portfolio is. The top 10 holdings are always a slice of important information to investors. Investors can simply compute the total weightings of the top 10 holdings to see whether the fund is too focused, by comparing with the fund's peers. A rule of thumb would be if the weightings of top 10 holdings exceed 50 percent of asset size, the portfolio is constructed relatively focused. Secondly, investors should also read the number of holdings of the fund. In general, the higher the number, the more diversified the portfolio is.

Diversification is not the only way for risk management. There are other risk management strategies like hedging to control the risk. Derivatives including forward and future contracts are gaining popularity for funds for hedging purpose nowadays but they are quite difficult for investors to measure how well they work in terms of risk control. In this case, funds' past records and Morningstar ratings can tell us something, although not all.

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About Author

YT Kum, CFA  YT Kum is a consultant for Morningstar, contributing to manager selection and asset allocation activities in Asia, and is responsible for providing investment thought leadership on topics relevant to investors in Asia.

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