Global financial markets are experiencing a lot of volatility due to rising inflation and a slowdown in the global economy. This is not good news for any investor, whether you’re in Africa or abroad.
Volatile markets bring uncertainty and generally make investments riskier. While there’s greater potential for gains, there’s an equally greater potential for losses — this is something no one wants when it comes to finances. In fact, 43% of the respondents in one survey revealed that they are too nervous to invest in the market right now. But this doesn’t have to be the case.
If you’re looking to build wealth through investing you need to accept that market volatility will always be there. What’s important is knowing how to minimize your financial risk in the long term.
One way to do this is through strategic portfolio diversification. The main goal of portfolio diversification is to limit the impact of volatility on a portfolio and maximize returns.
In view of this, let’s look at how you can hedge against investment risk by making your portfolio more diverse.
Invest in different asset classes
Although this may seem complex, at its core, this strategy is about spreading your portfolio across several asset classes. An asset class is a grouping of investments that exhibit similar characteristics and are subject to similar rules and regulations. The financial instruments that make up an asset class will often behave similar to each other in the markets.
The main types of asset classes are:
- Equities (stocks). These are financial instruments that give an investor ownership of a portion of a company.
- Bonds (fixed-income stocks). These are debt instruments issued by governments and companies to borrow money from investors. The investor makes money in the form of fixed interest payments.
- Money market and cash equivalents. Cash offers low investment risk, but it also tends to offer low returns compared to other asset classes.
- Real estate. This can be either residential or commercial properties.
- Commodities. These are primary agricultural products or raw materials that can be traded. Examples include gold, silver, crude oil, natural gas, and wheat.
- Alternative investments. Cryptocurrency is one of the most common types of these investments.
Different asset classes respond differently to economic changes. In other words, economic changes and market movements that affect one asset class will typically not affect the others. As such, when you invest in a range of asset classes, you can mitigate financial risk.
Let’s explore asset class correlation a bit further.
Asset class correlation
If two asset classes are in correlation, they will move up and down together. That means if you have invested in asset classes that correlate, and the market moves against you, you will likely experience huge losses.
The secret to diversification is non-correlation. The less the correlation between the asset classes you invest in, the higher your chances of avoiding financial risk. For instance, commodities such as gold and alternative investments like cryptocurrency tend to move in a direction that’s opposite that of the stock market. They can, therefore, be used to balance out equity risk.
Besides asset classes, you can also look at diversification from an industry or geography perspective.
This brings us to another portfolio diversification strategy — expanding your portfolio globally.
Build a global portfolio
The Johannesburg Stock Exchange (JSE), which is Africa’s largest stock exchange, has around 400 listed companies. However, some sectors are either underrepresented or not represented at all on this stock exchange, and so diversification opportunities are limited. On the other hand, the World Federation of Exchanges has close to 60,000 listings.
Given that the goal of investing is to create a well-balanced long-term investment portfolio, it makes sense to venture beyond your country and continent and look for opportunities globally. Investing beyond a single country or continent can offer better protection against the financial and political fluctuations happening in your region.
How soon you get started on building a global portfolio will depend on how much money you have set aside for investment. Of course, there are simpler ways to enter the global market. For instance, with Chipper Cash, you can start buying fractional shares in international, publicly traded companies for as little as $1.
Having some of your portfolio offshore gives you access to a wide range of companies and sectors you wouldn’t have access to otherwise. One thing to keep in mind though is how different tax rules and regulations in various countries will affect your investments. You want to avoid losses that can come from not complying with what’s required in specific jurisdictions.
Beware of over-diversification
While diversifying your investment portfolio is a good strategy, there is such a thing as overdoing it.
Over-diversification occurs when the additional returns that a new investment brings are less than the incremental risk the investment carries. It’s essentially watering down your portfolio with too many different investments for the sake of just diversifying. Doing this will not only make it difficult to keep up with your portfolio, but it may reduce your portfolio returns to a point where your portfolio is more risky than rewarding.
There’s no absolute cut-off point that distinguishes an adequately diversified portfolio from an over-diversified one. However, as a general rule of thumb, most investors will peg a sufficiently diversified portfolio as one that holds 20 to 30 stocks across various market sectors.
The best way to avoid over-diversification is to keep your investments at a manageable level that is tailored to your particular investment risk appetite. This could mean only putting money in your top 10-most reliable companies or specific sectors.
In any case, you don’t want to “di-worse-ify” your portfolio. Learn the markets and research what works for you; there’s no such thing as arbitrary diversification.
Hedge against investment risk the smart way
This may be cliché, but when it comes to investing, you don’t want to put all your eggs in one basket. No investor can ever be sure of how the financial market will behave in future, so portfolio diversification is crucial no matter the market conditions.
A good financial platform will help you to diversify your portfolio without any hassles. Take Chipper Cash, for example. You can instantly convert your local currency and start investing in cryptocurrency or stocks — that’s two different asset classes right there.