{"id":10397,"date":"2014-07-26T14:53:50","date_gmt":"2014-07-26T18:53:50","guid":{"rendered":"http:\/\/goldstocksforex.com\/?p=10397"},"modified":"2014-07-26T14:53:50","modified_gmt":"2014-07-26T18:53:50","slug":"diversification-the-only-free-lunch-in-investing","status":"publish","type":"post","link":"https:\/\/thepatientinvestor.com\/index.php\/2014\/07\/26\/diversification-the-only-free-lunch-in-investing\/","title":{"rendered":"Diversification – the only ‘free lunch’ in investing"},"content":{"rendered":"

Diversification is often referred to as “the only free lunch in investing” because it affords investors the opportunity to reduce investment risk without reducing returns. Most investments involve a trade-off between risk and return, with higher returns requiring investors to expose themselves to greater risk. But effective diversification allows investors to reduce risk, by spreading their investments, while maintaining higher levels of return.<\/p>\n

What is effective diversification?<\/h3>\n

Not all diversification is effective. Many investors buy a wide range of stocks in the belief that this will protect them from risk. The benefits of such diversification are likely to be insufficient if the stocks are all listed on the same exchange and selected using the same method. The entire portfolio will tend to rise and fall in unison — as in the well-known adage “a rising tide lifts all boats.” The key is to select stocks or investments that have low correlation.<\/p>\n

What is correlation?<\/h3>\n

Correlation is the degree to which separate investments rise and fall together. Correlation measures the tendency of investments to advance or decline independently of each other. The correlation coefficient, identified by the symbol r<\/i>, expresses the level of dependency between two variables (stocks in our case). Values for the correlation coefficient range from 1.0, for stocks that are perfectly correlated, to -1.0 for stocks that move inversely to each other.<\/p>\n

Only two shares of the same stock, like BHP Billiton, are likely to have a correlation as high as 1.0. But stocks from the same sector are likely to share high values. And stocks from the same market are also likely to share a reasonable degree of correlation in larger time frames (i.e. the primary cycle).<\/p>\n

You are also unlikely to find stocks that are the perfect inverse of each other — a coefficient of -1.0 — except possibly from an index ETF and its bear counterpart.<\/p>\n

We are not necessarily looking for stocks with negative correlation, however, but stocks or investments with low correlation — closer to zero than to 1.0. As you can imagine, going long and short the same stock would protect you from any variation in prices, but would not deliver much in the way of return. If we had a spread of investments with low correlation (i.e low dependency) their price movements will tend to offset each other, providing a smoother portfolio return.<\/p>\n

3 Ways to achieve diversification<\/h3>\n

We are likely to find investments with low correlation using three different techniques:<\/p>\n