Economic shifts and market conditions are susceptible to change due to unforeseen events. This can affect various aspects of life, including asset classes. For example, during the COVID-19 pandemic, many companies suffered losses and even bankruptcy. The performance of these companies started to decline, leading to a decrease in their stock prices, particularly in the travel and consumer sectors. Conversely, those in the healthcare sector benefited from the pandemic.
Another example is the Russia-Ukraine war in 2022, which significantly raised commodity prices, benefiting the share prices of companies in the energy and commodity sectors. However, this situation also caused inflation, prompting central banks to significantly raise interest rates, resulting in a drastic fall in bond prices.
Dealing with Volatile Market Conditions
An investment portfolio concentrated in only one type of instrument carries a higher risk than a portfolio diversified into several different investment instruments. Since each instrument is influenced by different factors, the potential gains from one instrument can cover or even exceed the losses incurred in another.
When is Diversification Necessary?
Diversification is necessary under the following situations:
- When there is high economic and market uncertainty
- If the investor’s portfolio is too concentrated on specific assets
- When a large amount of funds is allocated for investment
In simple terms, diversifications aim to optimize portfolio allocation by maximizing total return while reducing the risk when market movements are unpredictable.
Mutual Funds as a Diversification Strategy
Mutual funds can be used to implement diversification in investment. Each type of mutual fund offers a different form of diversification.
- Balanced Funds provide diversification by including various asset classes such as money market, bonds, and stocks. These different asset classes can offset each other. For example, if the bond market declines and the stock market conditions are rising, potential losses from bonds can be balanced by the increase in stock value.
- Aside from Balanced Funds, other mutual funds also address diversification strategies in terms of industry sector and timeframe.
- Money Market Funds offer diversification by including various types of companies, even though they contain deposit products and money market asset classes.
- Equity Funds diversify investments across multiple companies in different sectors and with varying market capitalizations.
- Fixed-income Funds diversify investments in bond asset classes with various maturity periods ranging from short to long tenors.
Is Diversification a Guarantee Against Losses?
Diversification doesn’t eliminate the risk of loss for an investor,but it does minimize it. Losses can still occur if an entire asset class experiences a downturn. Therefore, it’s important to keep up with the current economic conditions and make wise choices when selecting investment products.
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