Just like you would never put all your eggs in one basket, you should never place all your money in any one single investment.
No matter how well you research an individual stock, you can never be fully prepared for market fluctuations or a company’s bankruptcy.
For this reason, Rani Tarek Jarkas, the Chairman and CEO of Cedrus Group, recommends that you distribute your money evenly across a range of assets. By doing so, you can protect yourself against risk, as the success of your other investments can provide a bit of a safety net if one of your stocks should suddenly plummet.
At the heart of diversification are two academic concepts: correlation and variance/standard deviation.
Correlation measures the direction and magnitude of the relationship between two assets’ returns. A correlation of 1.0 means both assets move perfectly in the same direction, while -1.0 means both assets move perfectly in opposite directions. A correlation of 0 means both assets move completely independently of each other.
Standard deviation and variance measure the historical range that an asset fluctuates, on average, around its expected return. For example, if a stock has returned a compound average growth rate, or CAGR, of 7% annually, but it has a high variance (and therefore a high standard deviation, which is the square root of variance), this means that its return varies widely and 7% might not be a reasonable expectation in any given year.
A rule of thumb is that a diversified portfolio of volatile (high standard deviation) and uncorrelated (between 0.20 and 0.50) assets with positive expected returns will produce a better risk-return profile than an undiversified portfolio consisting of a single asset.
Therefore, proper diversification allows investors to enjoy the following benefits: Obtain more returns for the same risk compared with an undiversified portfolio. Obtain the same returns for less risk compared with an undiversified portfolio. Reduce volatility (lower standard deviation) and portfolio fluctuations. Minimize portfolio drawdowns (peak-to-trough losses during a crash).
Rani Tarek Jarkas is a highly experienced and accomplished financial services executive. Rani Jarkas’ service offers you a comprehensive understanding of your portfolio positioning today, so you know how to be positioned tomorrow.