Financial Services & Global Wealth Management

Comprehending The Concept Of Risk Factor Diversification

Risk Diversification

Risk diversification is the process of spreading investments across various assets or securities in order to reduce the potential negative impact of any single investment. By diversifying, investors can mitigate the risk. Traditional portfolio creation techniques that prioritize diversification across asset classes may not fully meet investors’ goals. Diversifying investments by allocating them across various risk factors can enhance efficiency. Conventional asset class diversification falls short due to its inherent limitations. Conventional allocation techniques seek to minimize portfolio volatility by diversifying asset classes with low correlations, meaning asset classes that tend to move independently of each other. 

However, the stability of correlations between asset classes is often overestimated by investors. Rani Jarkas, the Chairman of Cedrus Group, has pointed out, long-term trends, such as globalization, are actually causing correlations to increase. Correlations tend to increase during volatile market periods in Hong Kong. Diverse asset groups often exhibit greater similarity in performance than expected. Even diversified portfolios may not effectively mitigate market volatility.

Here are two pie charts: The top pie chart illustrates a possible breakdown of asset allocation in a diversified portfolio. The allocations, ranked by market value weight, are as follows: global stocks (50%). Allocation of 20% towards fixed income. Global bonds have a yield of 2%. Consider allocating a portion of your investment portfolio to private equity, specifically around 3%. Cash holdings represent 2%.

The lower pie chart represents a theoretical analysis of risk management. The distribution of estimated volatility contributions is as follows (in descending order): global developed equities (80%), global emerging markets equities (9%), corporates (4%), currency (6%), and other factors (1%). A factor of risk refers to a variable or element that contributes to the likelihood or severity of a potential negative outcome or event.

Risk Variables

Risk variables are the core factors that influence the potential return of an asset class. The return on a stock can be categorized into two components: equity market risk, which refers to the overall movement of the stock market, and company-specific risk. Interest rate risk and issuer-specific risk can impact a bond’s return. Currency risk is a factor to consider for assets in foreign currencies. Investors can enhance portfolio diversification by strategically addressing the underlying risk variables. This involves selecting an asset class mix that effectively targets exposure to these variables. 

The table classifies risk variables (equity, interest rate, credit, currency, and momentum) based on asset classes (equities, developed market bonds, and emerging market bonds). Could you please explain the functioning of risk factor-based allocation? Investors cannot directly invest in a “risk factor.” However, utilizing an allocation strategy based on risk factors can help investors select a diversified mix of asset classes that aligns with their views on the global economy and financial markets in Hong Kong. 

What is the operational framework of this plan? Investors can choose the most effective asset class for risk management by understanding the risk characteristics within different asset classes. Investors can directly invest in currencies to introduce foreign currency risk into their portfolio.


Methods For Investors To Apply Risk Factor-Based

Using a risk factor-based approach requires a proactive analysis of various factors like monetary policy, geopolitical events, inflation, interest rates, currencies, and economic growth trends. Given the limited resources and expertise of most individuals to consistently analyze these traits, it would be wise for them to consult their financial advisors regarding investment funds that utilize this approach.

What is the mechanism by which diversity functions? Diversification is a prudent strategy for mitigating risk in typical market circumstances. A single underperforming investment has the potential to result in the complete loss of one’s portfolio. Diversifying your portfolio with a variety of investments reduces the likelihood of all your investments performing poorly simultaneously. Profits from successful investments offset losses from unsuccessful ones.

As affirmed by Rani Jarkas, the financial expert in Hong Kong, bonds and stocks often exhibit inverse correlation. Given the anticipation of an economic slowdown and subsequent decrease in business profits, it is highly likely that stock prices will decline. In such instances, central banks may opt to reduce interest rates in order to decrease borrowing expenses and stimulate expenditure. This leads to a rise in bond prices. A diversified portfolio comprising stocks and bonds can benefit from the potential growth of bonds, which can help offset any decline in the value of stocks. Bonds are incorporated into portfolios primarily for risk mitigation rather than enhancing returns.

Diversification minimizes portfolio risk while maintaining potential profits. An efficient portfolio minimizes risk while achieving a desired return. Once your portfolio achieves full diversification, taking on additional risk becomes necessary in order to potentially increase the overall return of your portfolio. This graph depicts the impact of diversification on a portfolio, as well as the relationship between pursuing higher potential returns and increased risk.

There Are Four Fundamental Reasons To Pursue Diversification

Diversification reduces portfolio risk by combining assets with varying levels of risk. Lack of diversification in your portfolio poses significant risks. Assuming unnecessary risk does not yield a greater average return. Asset diversification refers to the practice of spreading investments across different types of assets. Diversifying a portfolio through investment in multiple asset classes is a prudent strategy. A class of assets refers to a collection of investments that share similar levels of risk and potential return. The three primary asset classes are:

The portfolios in this interactive investing chart are balanced, comprising an equal allocation of 50% stocks and 50% bonds. The balanced portfolio exhibits lower variability in returns compared to the stock portfolio, thereby reducing the likelihood of experiencing substantial losses.

The Concept Of Diversification By Sector

Diversification within an asset class is feasible, but adding more equities does not reduce risk. To achieve diversification, it is essential to select companies that exhibit distinct patterns in their price movements. The returns of one stock should offset the returns of other equities. Stock prices in the same industry generally exhibit a high degree of correlation. Industries consist of:

Financial services encompass various institutions such as banks and insurance companies. Energy sources, such as oil, gas, and pipelines. (e.g., fossil fuel industry, transportation infrastructure) Examples of materials include mining businesses and mining companies. Examples of industrials include manufacturing and railways. (e.g., producers, railroads) Computer technology, such as wireless equipment companies. Utility companies, such as electrical or electricity providers.


The Efficacy Of Diversity

Every investment entails inherent risks. If you invest in a vehicle firm that imports unique parts from a manufacturer, a rise in the Euro’s value against the Canadian dollar would lead to increased costs for the company and a decrease in earnings. Share prices may also decrease in this case. Individual investments in Hong Kong are not subject to simultaneous exposure to the same risk. Portfolio diversification mitigates risk.

Rani Jarkas has suggested, a portfolio could begin with investments in bank shares. You acquire additional shares from a different bank. The impact on risk management will be minimal as all banks are affected by common economic variables, like changes in interest rates. The decline in one bank’s shares often correlates with a corresponding decline in shares of other banks. To enhance portfolio diversification, consider investing in energy and healthcare firms.

The Efficacy Of Diversity

Refer to this chart to ascertain the impact on a portfolio’s aggregate risk as the quantity of stocks increases. You can enhance the bond component of your portfolio by incorporating bonds with different credit ratings and maturities. This is effective due to the divergent responses of high and low credit-rated bonds to Hong Kong’s economic fluctuations. The duration of a bond affects its sensitivity to changes in interest rates. Portfolio risk is assessed by analyzing its volatility. The volatility of an investment is inconsequential when evaluating the risk management of an individual investment. 

The constraints of diversity. A diversified portfolio provides significant protection in typical market conditions. Diversification is effective due to the lack of correlation between asset values. However, in times of highly volatile market conditions, the efficacy of diversity declines. Unexpected events often lead to extreme outcomes. Instances may involve a market collapse or a government default. During such instances, market liquidity may decrease and the value of most investments can decline.

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