Worldwide diversification should include a number of assets that are relatively safe and that are perceived to be predictable in terms of the way they perform. When diversification is about asset allocation to potential places that are outside of the United States, the world will have to be broken down into regions, at least until the global financial crisis has receded. Here are some examples:
In the case of equities, they might include companies from the US that have excellent free cash flow yield as well as the ability to grow capital at reasonable levels, particularly with regard to growth rates. For bonds, companies should be considered with regard to their bonds’ liquidity and credit quality. If a company has had a history of debt defaults or has become unprofitable, it may be wise to avoid it altogether.
In the stock market, this means a complete avoidance of companies that have never been publicly traded. In terms of bonds, it means a commitment to only investing in companies whose ratios of debt to net assets (DTNA) are substantially higher than that of other companies in the same sector. DTNA is the ratio of a company’s total assets to its total liabilities.
For many people ca n’t escape outside risk factors by ditching everything they own and concentrating on a single asset. And you can’t afford to disregard the possibility of being wrong. You can always invest in areas that are less risky. This is one way to minimize the risks inherent in diversification. If your goals are to use a particular financial instrument or group of instruments to complement your broader investment strategy, your decision of what to hold will often reflect a limited understanding of its real value. It is far better to make a guess than to make an incorrect decision. There are significant differences between a particular financial instrument and all others. Only an informed investor would pick a currency based on its strength, while relying on interest rates to determine a foreign currency.
As a general rule, when you are choosing assets for diversification, your main purpose is to find a weighted average of the most important aspects of the asset. Risk and returns are important, but they are not the only consideration. Important as they are, they are not the only considerations.
One important aspect of how a financial instrument will perform in the future is that it is underwritten, as it will be subject to significant aspects of risk. Another important aspect of its risks are the price/earnings ratios, which reveal the company’s ability to pay its bills.
The analysis of financial instruments is different from that of other types of securities. Instead of looking at the return on one security as a measure of how much risk there is in a particular financial instrument, an investor will look at the relative strength of other financial instruments. This is different from assessing risk as a measure of the return on one security, but it is nevertheless a major risk factor.
For those investors who are especially concerned about risk, financial instruments should be evaluated with the aim of eliminating or reducing risk. After all, whether the risk is in one security or in all financial instruments is immaterial. For the most part, risk is considered a secondary consideration in the analysis.
Keep in mind that it is possible that an investor might end up worse off if they do not do an independent analysis of their risk. So a well-planned diversification strategy can help the investor by reducing the risk that they will fall into the same situation that they were trying to avoid. Avoiding being burned at the poker table also reduces their risk.
