By Ebenezer ASAFO-ADJEI& Stanley SOLAGAH
Every activity worth doing – including the most basic activities such as eating, sleeping, taking a stroll down the street, etc.- carries some degree of risk with no certainty of guaranteed outcome, even when the best-known method or technology is deployed.
This saying is also true for investment in financial securities or any other form of investment. Peter Lynch, an American investor and mutual fund manager, put it more succinctly. “In this business (of investing), if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten.”
This quote encapsulates the unpredictability of investments and the importance of not relying on a single asset class to achieve your financial goals. As Warren Buffett put it, “the risk comes from not knowing what you’re doing.” Therefore, concentrating your investment in one asset class concentrates your risk and increases your chances of loss.
By spreading your investments across different assets, sectors, or geographic regions (diversification), you reduce the impact of any one investment’s poor performance on your overall portfolio. In so doing, you are better placed to achieve your financial goals and safeguard your financial security.
This process of reducing risk (volatility) in one’s investment portfolio by tactically allocating capital to minimise exposure to a single asset class is what investment professionals refer to as diversification.
Diversifying capital into various asset classes such as stocks, bonds, cash, and other alternative investments can generate an optimal risk-adjusted return for a given portfolio and requires periodic portfolio rebalancing to navigate market fluctuations more effectively, which helps to stay on track towards achieving one’s financial goals.
Building a well-diversified investment portfolio has several benefits for the investor, including:
- Risk Management: By optimally spreading the investments across different asset classes and sectors, the investor reduces the impact of poor performance from one industry/sector/asset class on the overall portfolio performance.
- Potential for Higher Returns: Diversification enables investors to generate returns from multiple sources, enhancing overall portfolio performance.
- Stability: A diversified portfolio provides stability by balancing high-risk and low-risk investments in line with the investor’s risk appetite.
- Exposure to new opportunities and growth sectors: Diversification allows active and adventurous investors to explore untapped opportunities in emerging industries and sectors with high growth potential.
- Helps navigate market downturns: Under volatile market conditions, including assets with a low correlation to the market, cushions a portfolio against a market downturn.
Practical Steps to Creating a Diversified Portfolio
Achieving a diversified investment portfolio starts with the capital allocation process. After setting your investment goals and determining your risk appetite and investment horizon, it is important to identify the asset mix that optimises your portfolio returns by allocating capital between risky and less-risky assets.
While a risky investment has the potential to offer superior returns than other investments, the risk of loss is equally higher. Investing in risky assets could wipe out your principal under extremely adverse market conditions in the short term but generally tends to provide superior returns over a longer investment horizon than less risky assets. Such risky assets may include equities, distressed bonds and private equities.
A less risky investment, on the other hand, provides a more predictable stream of income over the tenure of the investment with a limited risk of losing the principal invested. Examples of less risky investments include but are not limited to treasury bonds, bills, notes, money market instruments, savings accounts, etc.
The second step to diversification is asset allocation. This decision process requires identifying appropriate asset classes in step one that fit into your risky and less risky bucket.
Each asset class identified constitutes a percentage of the portfolio’s total value, which adds up to 100%. The portfolio’s risk will be lower if the asset class identified is diverse. Asset classes include stocks, bonds, commodities, money market instruments, cash, etc.
After achieving an optimal asset mix, the next step in the diversification process is choosing the individual investments or securities under each asset class. This process is termed security selection.
Fixed-income securities could be bonds, bills or other money market instruments. Bonds could be sovereign, supra-national, municipal or corporate bonds and may be investment-grade or high-yield bonds, each carrying a different risk.
It is necessary to seek diversification even within an asset class, which may require selecting securities within the asset class across different industries and sectors. An example may include selecting bonds across various sectors, such as telecommunication, media and technology, financial services, energy sector, etc. into your bond portfolio.
A practical guide to achieving portfolio diversification in Ghana
Diversifying your portfolio in Ghana requires careful consideration of the available investment options and their potential risks and returns. By spreading your investments across various asset classes and sectors, you can mitigate risk and enhance your chances of achieving long-term financial growth.
Always seek advice from investment and finance professionals to tailor a diversification strategy that aligns with your investment goals and risk tolerance.
In Ghana, investors have a variety of options to achieve diversification. Here are some investment vehicles to consider:
| Investment Vehicles | Diversification Benefits |
| Equity | The Ghana Stock Exchange (GSE) offers opportunities to own shares in various sectors, including banking, telecommunications, manufacturing, and consumer goods.
A diversified equity portfolio may include carefully selecting stocks from across the represented sectors on the GSE backed by research. |
| Bonds | Government bonds, corporate bonds listed on the Ghana Fixed Income Market (GFIM) and other privately placed corporate bonds provide fixed-income diversification options for fixed-income investors.
Treasury bills and other money market instruments (fixed deposits, Commercial Papers, Certificates of Deposits, etc.) also provide short-term and more liquid fixed-income investment options at relatively low returns, all things equal. |
| Real Estate | Investing in real estate, particularly in urban areas like Accra, Kumasi, and other fast-developing areas, can provide rental income and capital appreciation while hedging inflation risk. Liquidity in the Ghana real estate market is low but offers enormous potential as the mortgage industry in Ghana evolves. |
| Mutual Funds | Mutual funds offer a way to invest in a diversified portfolio managed by professionals by investing in a mix of asset classes such as equities, bonds, and other assets. |
| Commodities | Gold is a safe-haven asset and a significant contributor to Ghana’s GDP and economy. Investing in gold-backed ETFs offers exposure to different aspects of the gold market. It offers a good hedge against inflation and currency depreciation and performs well during a recession.
With the Ghana Commodity Exchange now in operation, trading commodities futures may be an investment possibility in the future. |
| Foreign Investments | Diversifying outside the Ghanaian market can protect against local economic downturns. The options include investing in international mutual funds, ETFs, other sovereign bonds, stocks, bonds or currency and derivatives. |
| Private Equity (PE) and Venture Capital (VC) Funds | Supporting small and medium-sized enterprises or startups is risky but offers high reward potential. PE/VC firms, though nascent in Ghana, offer opportunities to invest in providing startups with high growth potential in Ghana and beyond. Consider agnostic sectors with high growth potential, such as fintech, renewable energy, and technology. |
| Agriculture | Agriculture remains the backbone of Ghana’s economy. Investments in agribusinesses, especially export-oriented agriculture such as cocoa, palm oil, and cashew nuts, can yield substantial returns. |
The Domestic Debt Exchange Programme (DDEP) in Ghana has had several implications for diversification within the country’s investment landscape, prompting both institutional and individual investors to reconsider diversification more carefully in their investment strategy. In this respect, diversification appears to be a dominant consideration to most investors in the post-DDEP, and investors are looking at portfolio diversification in the following ways:
- Reduction in Government Bond Dependence: Historically, domestic investors, especially institutional investors like pension funds and insurance companies, have been biased towards government papers due to their perceived safety. The DDEP-induced interest haircut and time-value losses on these bonds have triggered a gradual shift in appetite away from this heavy dominance. Investors are now considering alternative assets to improve their returns.
- Increased Investment in Equities: The stock market has seen increased activity post-DDE as investors increasingly diversify away from government paper into equity in response to DDEP-induced losses and depressed valuations. This shift supports increasing activity in the equity market, leading to price discovery.
- Growth in Real Estate Investments: Real estate has become an attractive option for investors looking to hedge against inflation and earn stable returns. The increased interest in real estate can drive growth in the construction sector and related industries, contributing to economic growth. Establishing Real Estate Investment Trusts (REITs) as investment vehicles for institutional investors to benefit from rental yields and revaluation gains continues to deepen the market.
- Expansion into Foreign Assets: Post-DDEP, investors are diversifying their portfolios into equities, bonds, and other financial instruments in the offshore market.
- Growth in Private Equity: The reallocation of assets due to the DDEP has seen an uptick in private equity investments. Investors seeking higher returns and diversification are increasingly turning to private equity funds, which offer opportunities for higher growth potential compared to traditional assets. This promotes long-term growth and supports innovation in various sectors, providing capital to fund emerging companies and startups.
Limitations to Enhancing Portfolio Returns through Diversification in Ghana
Although diversification is a key strategy for risk management and optimising returns, it has some limitations, especially within the investment climate in Ghana’s investment environment. Here are some limitations to diversification:
Cost of Diversification
Diversifying a portfolio incurs transaction costs and management fees and comes with some potential tax implications. In a frontier market like Ghana, these costs can be disproportionately high relative to the size of investments. There may also be regulatory restrictions on investing in Industries like the real estate sector for some classes of investors.
Limited Financial Instruments
Financial instruments like derivatives, ETFs, REITs, and other alternative assets are limited in Ghana, restricting investors’ ability to diversify across different asset classes. The bond market, while developing, still lacks depth and variety compared to more mature markets.
Market Size and Depth
The Ghana Stock Exchange (GSE) has a relatively small number of listed companies, limiting the range of equities available for investment. Liquidity on the market is also a key challenge, with trades invariably resulting in price fluctuations.
Access to Information
Limited access to reliable and timely information can hinder informed investment decisions. Transparency issues and the quality of financial reporting in some sectors can be barriers to effective diversification. Smaller investors may find it challenging to access the same detailed financial analysis and market data as larger institutional investors.
Regulatory and Political Risks
Sudden changes in government policies and regulatory frameworks, which have implications for businesses, can significantly impact investments. Regulatory risks can affect various sectors differently, complicating the diversification strategy. Political risks, such as changes in tax regimes or foreign investment policies, can also affect market stability and investor confidence.
Currency Risk
Foreign investments may benefit from Cedi depreciation, as gains are amplified when converted back to Cedi. However, offshore investors in Ghana face capital losses due to currency depreciation. Hedging currency risk can be costly and complex, limiting diversification strategies and reducing overall investment efficiency.
Therefore, investors need to be aware of market constraints, economic dependencies, regulatory risks, and the costs associated with diversification. Understanding these limitations can help in crafting a more effective and realistic investment strategy. Investment and finance professionals can provide valuable insights and help you navigate these challenges.
Diversification of Investment Really Matters
Achieving portfolio diversification is, thus, fundamental to achieving your financial goals. Diversification acts like a shock absorber against market volatilities in that when some securities are rising in value, others may fall in value depending on market/industry or sector-specific conditions and general macroeconomic developments. Diversification thus helps to smoothen out returns.
However, over-diversification can also hurt a portfolio’s return without meaningfully reducing portfolio risk. Engage an investment consultant to advise on developing an optimal investment portfolio.
This is a CFA Society Ghana Advocacy Op-Ed
About CFA Society Ghana
Inaugurated in 2018, CFA Society Ghana is part of a prestigious network of CFA Institute member societies that lead the investment profession globally by promoting the highest standards of ethics, education, and professional excellence for the ultimate benefit of society. CFA Society Ghana represents the interests of investment professionals in Ghana through advocacy, education, events, and professional development.
Appendix (References)
The post Spreading the risk, growing the returns: why diversification of investment matters appeared first on The Business & Financial Times.
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