A lot of people who give you advice on what to buy and what not to buy are the brokers who sit near your place where you live. Now these brokers will generally execute your trades via some broker dealers. These

Investors have been through difficult times. It is uncertain how long these uncertainties will continue. They have been seeing their portfolios tumble in a matter of days. It is hard to be immune from the vagaries of gyrating investing markets.

Global Investment

Quite often we hear about the need for minimizing the risks of investment. One of the recommended strategies is to diversify globally in the emerging countries. This is based on the assumption that the world is changing fast with new financial powerhouses in Asia, Middle East, South America and Europe.

It has been thought that the world is becoming less and less dependent upon US economy and that economic activity is moving away from US shores. The fall of US dollar and the continuing rise of Euro are cited as examples of dwindling stronghold of US finances on the global markets.

Global Demand is Still Driven by US

Second half of 2007 and the beginning of 2008 put stock and bond markets in turmoil. It is not clear whether the Fed rate cuts and US Government stimuli package will bring out the US economy from the woes of economic slowdown.

However, we have noticed one important thing and that is that the world capital markets are still driven by US markets. US economic slowdown is having an impact throughout the world. The way world stock and bond markets behaved soon after the turmoil in the US markets was a little surprising to the votaries of global investment.

The Rationale

How can we account for the steep fall in world capital markets and the subsequent rise?

We see that US is a huge market for Chinese exports. Any economic recession in the US means negative income. With less money in their pockets, the consumers will not be in a position to purchase more from China. This will impact Chinese exports and consequently its economic growth.

It was assumed that with growing involvement of Chinese economy with Europe, China will be less dependent upon US. However, with less income, US consumers will not be able to buy more from Europe as well. If US spends less in Europe, Europe in turn will buy less from China.

Same is the case with other economies. This only underlines the fact that US cannot be written away as yet. World seems to be deeply involved with US economy. Globally US is not only a major consumer and investor but also a leader in technology. So it seems that there is no escape from the affects of US economic changes for a long time to come.

Investors Beware

From the above the only lesson that we learn is that investors need to exercise more caution while investing globally. If economic conditions worsen in the US, there is no guarantee that we will remain unaffected while keeping our capital thousands of miles away.

World is still looking towards the US not only economically but also as a policeman. What is true internally may not be different externally. Investors have to put in place risk controls and launch businesses with due regard to the US economy and capital markets.

Bonds offer a stable-return for long-term investors. They are often referred to as “fixed-income” investments because they provide a stable rate of return (called yield) for investors.

Bonds are also the most common hedge against stock volatility, because stock market volatility will not affect bond prices. But it is a challenge for individual investors to benefit from bonds. Most bonds are offered in denominations of $1000 or higher, so an investor will need upwards of $50,000 to put together a well-diversified bond portfolio.

Enter fixed-income funds. Fixed-income funds offer small investors a way to invest smaller amounts into this essential asset class.

Risk

Investing in bonds carries two main risks: Credit Risk and Interest Rate Risk.

Credit Risk

Credit Risk is the risk that the bond’s value will decline because the credit rating of the issuer falls. Many bond investors holding auto manufacturer and airline bonds have experienced this in recent years.

Government bonds are typically immune to credit risk, but emerging markets bonds are an exception. In recent years Brazil and Argentina have defaulted on obligations. Currently, Iraq bonds are at a high risk of default.

Interest Rate Risk

Bond values fall when interest rates rise. While most everybody knows this rule, few understand how and why it works.

When current yields (interest rates) rise, then new bond issues are at a higher yield than old issues. So, a bond that’s six month’s old will lose value if interest rates have risen, since new bonds have a higher yield.

Conversely, if interest rates are falling, a bond issued six months ago will be worth more than its original purchase price, since current issues offer a higher yield.

Mutual Funds

Interest rate risk and credit risk and bond prices in general are highly specialized areas that most individuals don’t have the resources or the expertise to enter into. Furthermore, the various types of bonds issued (asset-backed, convertibles, munis, high-yield) make the bond market appear overwhelming.
Fixed-income funds can offer the stable returns and expertise of experienced bond traders at a reasonable entry-level.

The best funds will allow the management to invest in a widely diversified array of bonds. Management is best able to assess the market and determine which issues are likely to perform best.

Sometimes short-term low-yield Treasury securities will be the best fixed-income investment. At other times, long-term high-grade corporate notes will be favorably priced. In the 1980s and 1990s, high-yield junk bonds, issued by companies with low credit ratings, performed best.

For this reason, diversified bond funds work best for individual investors. Such funds will benefit from all possible issuers and types. The PIMCO Total Return Fund, PIMCO Diversified Income, and the Dodge and Cox Income Fund are excellent choices with reasonable expense ratios.

Municipal bond funds offer a tax-efficient income stream, as the returns from these funds are deductible from most state and local taxes.

You’ve no doubt heard the expression “don’t put all your eggs in one basket”. Nowhere is this saying more relevant than in the realm of investing. Studies have shown that diversifying your investment portfolio, i.e. not putting all your eggs in one basket, decreases a your portfolio’s risk substantially: yes, they actually had to do a study to determine this. That probably comes as no shock to you. What may be surprising is that diversification can also increase your returns at the same time.

Modern Portfolio Theory is the study of how risk-averse investors can build portfolios to maximize expected investment return at any given level of portfolio risk. Over the years, we have gained an ever greater understanding of how diversification works to both increase returns and decrease risk. At its core, diversification is about holding a portfolio of several different volatile asset classes that are not highly-correlated with one another. That is, your bond allocation should zig when your stocks zag and vice versa. Chances are, your real estate holdings or small-cap emerging markets stocks will be up when your large-cap US stocks are down, or your bonds will be up while your precious metals are down, or any combination thereof. Over time, these non-correlated asset class returns will counteract each other and greatly reduce the risk of your overall portfolio.

To be properly diversified, you need at least two non-correlated asset classes in your porfolio. US stocks and government bonds are the most common asset classes owned by investors, but there are many others. Real estate, precious metals, commodities, foreign stocks, emerging market stocks, and even small-cap stocks are all considered separate asset classes and offer different degrees of diversification benefits from large-cap US stocks and government bonds. You should own as many different asset classes as you feel comfortable owning without becoming overwhelmed by details in order to maximize returns and minimize risk.

One of the biggest benefits of mutual funds is that they provide the means for individual investors to achieve broad diversification in their investment portfolios. Although many wealthy individuals and institutions use mutual funds as at least the core of their portfolios, having considerable wealth is not necessary to construct a well-diversified portfolio with mutual funds. Indeed, it’s possible to assemble a well-diversified portfolio of mutual funds with as little as $100,000, a fairly well diversified portfolio with $50,000 and an adequately-diversified portfolio of index funds with much less.

Having a well-diversified portfolio is important for three reasons. First, diversification can best be described as not putting all of your eggs in one basket. Mutual funds are large diversified portfolios and thus provide automatic diversification within their respective asset classes. Investing in a number of mutual funds to spread your investable funds across a variety of asset classes increases your level of diversification and decreases your aggregate exposure to risk. As investment risk is measured in terms of volatility, decreasing aggregate risk decreases the volatility of the value of your portfolio, thus sparing you the roller coaster ride that you would experience if you held only a single asset class in your portfolio, such as large-cap domestic stocks.

Second, although expected return diminishes with risk, the relationship is disproportionate and favors return. Well-conceived diversification has the potential to considerably reduce the aggregate risk of your portfolio at the cost of a relatively small reduction in your expected return. So you get a much smoother ride for a minimal cost.

Third, over the past 25 years or so, there have been a number of studies conducted that have concluded that asset allocation accounts for between 90% and 96% of your success as an investor, where success is defined as maximizing return at a level of risk that is consistent with your level of risk tolerance. Individual security selection accounts for the rest of investors’ long-term success. Now, just being broadly diversified won’t get you into that 90% to 96% range, but it’s a big step in the right direction. A viable model that defines the composition of an efficient portfolio is required to allocate your capital across the various asset classes in a manner that will reap the full benefits of diversification.

Diversification and asset allocation are not synonyms, as diversification is just a part of asset allocation. Diversification is a matter of degree; it describes the degree to which you have diversified away company-specific risk. Full diversification within a market, in theory, eliminates all company-specific risk, leaving your portfolio exposed only to systematic risk, which is the risk inherent in the market as a whole. So, that brings up the obvious question: What is The Market?

The S&P 500, Russell 1000 and Wilshire 5000 are often used as proxies for “The Market.” But they’re only proxies for the U.S. stock market. To be fully diversified, you would have to be invested in all of the publicly traded securities (stocks, bonds, real estate and commodities) worldwide and your investments would have to be broadly diversified within all asset classes in that aggregation. This can actually be achieved by holding a collection of index funds.

Asset allocation describes how your capital is distributed to the diversity of asset classes you have chosen to hold in your portfolio, i.e., your investment universe. If you had chosen full worldwide diversification, your next step would be to determine how to allocate your capital across that aggregation of asset classes. One possibility would be to hold what’s known as the Market Portfolio. To do this you would have to invest in all those asset classes on a market capitalization-weighted basis. That would by definition be an efficient portfolio and constructing such a portfolio is possible with index funds. It’s also possible with regular mutual funds, but getting and maintaining the appropriate weightings would be pretty tricky and require a lot of time and effort.

Beyond the Market Portfolio, there are just about as many ways to select asset classes and allocate capital as there are portfolio managers, investment advisors and newsletter editors. Although they’re mostly based on the same financial theories, everyone has their own model and their own forecasts to fuel their models. But going any deeper into asset allocation would diverge too far from the topic of this article…diversification.

In real estate it’s location, location, location. In investing it’s diversification, diversification, diversification. You must be adequately diversified, otherwise you will be exposed to too much risk with respect to your expected return. And no asset allocation model can compensate for under-diversification, as your chosen degree of diversification defines the investment universe across which asset allocation must take place. With thousands of mutual funds to choose from, there’s no good reason for anyone to be under-diversified.