I made my first dollar selling lemonade in front of my house. On a hot day, mothers in the neighbourhood would be happy to stop by and give an enterprising six-year-old a dime for a cool drink, even if it tasted like the lemons had travelled through on stilts.
After a couple of weeks, I had made a few dollars and my mother decided it was time to talk about savings plans. We had one place to take it - the local bank. I wasn't exactly happy to part with my new money, but it helped to know that the bank would pay me interest to hold on to it. That seemed fair since I wasn't going to be able to spend it on candy and sodas, which was my plan.
Sure enough, each time I visited the bank with more money that I had earned, the bank had added some money to the account too. There seemed to be no risk in leaving my money there; it was the biggest bank in town and the building itself looked formidable.
After years of saving, my mother introduced me to a new concept - investing. Ah, the risk factor in purchasing something that may gain or lose value. But, hopefully I would be rewarded for the extra risk I was taking.
My mother explained different asset classes. "There is that which you loan (my savings account), and that which you own (stocks and our house, for example)."
She said that the most intelligent way to invest was to choose to invest in some of each so that if there was loss, it wouldn't all happen at the same time. "Yes," I countered, "but that means that when one investment does very well, all my money won't be there." "True," she said, "but are you willing to risk everything for that one possibility? It works better if you don't put all your eggs in one basket."
I guess these early conversations helped me form my philosophy as an investment advisor. I still subscribe to that basic investing theory of diversification. There are plenty of studies supporting the value of asset allocation and diversification.
The best known is the one by Brinson, Hood and Beebower that quantified the importance of asset allocation. Yes, by diversifying your portfolio, you will be capping your upside potential, but you will also be capping your downside risk.
Harry Markowitz won the Nobel Prize in Economics for the notion that putting non-correlated investments together will make a safer portfolio. That is why when real estate mutual funds and gold ETFs (exchange traded funds) become available in India this year, it may be a good idea to discuss their use in your portfolio with your investment advisor.
REMFs are generally investments made in a pool of real estate properties that are held in a trust. Investors can buy them in the same way they buy MF units. The power of diversification is that as an investor you own a small chunk of many different properties, so if one fails, you still have the others.
Real estate is an asset class that does not correlate well to bonds or stocks. ETFs, on the other hand, are baskets of stocks (or other investments) of firms concentrated in a particular investment area. For example, gold ETFs will represent a portfolio of investments designed to provide returns matching the gold market index. So, you will own a little of many different gold investments.
As gold returns do not generally move in the same pattern as bonds, stocks or real estate (that is, it is poorly correlated), having a gold ETF investment in your portfolio may create a portfolio with less volatility.
I always thought that my mom's advice about eggs translated pretty well to many things in my life, but the most meaningful has been in my investing strategies. Diversification is a lot more boring than trying to find the latest hot stock, but it certainly helps protect against the inevitable market correction.
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