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The Need for Portfolio Diversification



Dear Speculators,

Many individual investors fail to diversify their portfolios and suffer heavy losses during market volatile periods. This leaves them frustrated as their dreams of making mega profits in the stock market has been replaced by the reality of mega losses. These losses can be avoided by diversifying your portfolio. Portfolio diversification is the act of investing funds into several asset classes and selective securities in order to hedge against risk and make decent returns.

Individuals can diversify by buying government issued securities, buying corporate bonds, purchasing equities and holding foreign currencies all in one portfolio. This allows such individual to reap gains in some of the securities and minimize losses. It is virtually impossible for any individual to consistently outperform the market on an annual basis. The key element of success is to maximize profits during an up year and as much as possible minimize losses during a down year.

Professional investors are able to make huge returns during good or bad economic periods by going long and short on securities simultaneously to meet their institutional goals. This sort of performance is only attainable through efficient portfolio diversification. We will now introduce you to a few easy steps we take in order to diversify our assets and make good return on investments. First, we use the EIC top-bottom approach to analyse and predict the economy, industry and company direction. This helps to narrow our stock picks. We go long on companies we expect to outperform and go short on companies we expect to under-perform. 

We advice beginners to stick to buying long, that is simple security purchase. Secondly, we plot a graph showing the relationship between the expected return of our selected stocks and their risks. We then select only stocks that possess the highest returns given a particular level of risk. This further reduces our portfolio size. Thirdly, we analyse the correlation of our selected securities and accept only stocks with high returns that are negatively correlated. Lastly, ensure that the intrinsic value of the individual securities is greater than their market prices. At this point our portfolio is ready for asset allocation and we will have eliminated any stock with positive relationship to another in the portfolio or random stocks with unpredictable price movements. This leaves with an effective portfolio. The final portfolio should be represented by securities in different asset classes where when combined should provide excellent returns, lower risk and may outperform the market portfolio.

This tips by no means promise any investor the ability to consistently outperform the market but serve as useful tips in security selection and portfolio diversification. Mutual funds and index funds are good ways to diversify your portfolio for small fund investors but these funds are not always effective. In the long term, index funds are very excellent options for strategic investors.

Signed:
Emeka Ucheaga,
Managing Partner,
Emeka Ucheaga Advisory

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