Diversification is the best way to reduce portfolio risk. It has long been understood that spreading your capital wisely can save you from unexpected asset deterioration, but exactly how to do that needs to be reconsidered.
There are a host of new products available to individual investors. Traditionally, people have been told that buying stocks and bonds is good enough to build a diversified portfolio. Still others, who really think they're savvy, spread their bets into small, mid, and large cap stocks. These people may even buy variable maturity debt securities, such as long and short term Treasuries or municipal bonds. While these techniques are a good start, the modern investor should use all the tools at their disposal, not just what worked in the past.
Exchange-traded funds (ETF's) change the old notions of portfolio management. Individual investors can now add commodities (precious metals, corn, wheat, soy, cattle, oil, natural gas, etc.), currencies, and specific sectors of the economy just as easily as they can add stocks.
Currencies, in particular, offer individuals a powerful alternative for hedging inflation and the decline of the US dollar, and adding a new level of diversification to offset adverse movements in stocks and bonds.
Negatively correlated assets held in the same portfolio reduce overall risk. Risk, as measured by variance of returns, can actually be lowered simply by holding assets that do not move in the same direction. For instance, if stock A decreases 70% of the time stock B increases, and vice versus, then you could construct a portfolio that has less total risk than either A or B by including both.
Someone holding predominantly US stocks in their portfolio should consider adding currencies that are negatively correlated. It turns out that Swiss Franc, Japanese Yen, and Swedish Krona move in opposite directions as US stocks, while Australian dollar, Mexican Peso, and Canadian dollar move in the same direction.
Holding Swiss Franc, Euro, Yen, or Krona would have yielded roughly between 12% and 17% in capital appreciation over the last year. Not only that, but each ETF has a dividend yield, representative of interest rates within each country.
There are multiple consderations in portfolio theory, but applying the basics can have far reaching benefits. Those concerned with dividends should hold the highest yielding ETF's, which include British pound, Australian dollar, and Mexican peso. On the flip side, income investors should avoid Swiss Franc and Japanese Yen.
In a world of increasing energy and food price inflation, you can see how important it is to hedge these risks. Currency ETF's offer such an opportunity; exposing investors to relativer currency price movements, as well as variable income opportunities from taking advantage of interest rate disparities in foreign markets.
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Rob Viglione is an writer, hedge fund manager, and real property broker and consultant. He speaks out on political and economic freedom on The Freedom Factory.
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