Diversify your Bonds: How to Hedge Against Investment Risk

“Always Diversify yo bonds, fam!”- Wu Tang Finance

The Total Return on $100 Radio Shack Bonds

One of The central concepts in investing is risk. Everytime you put money in an asset, you have no guarantees that the future cash flows of capital gains you’re expecting will materialize or even that you will get your capital back. 

Within that overall picture, there are so many different kinds of risk depending on the kind of asset, the location, the terms, duration and many other factors that are available for consideration. One good way to mitigate those risks, is to diversify. 

Diversification is a pretty simple idea: that you shouldn’t have all your eggs in one basket. It’s intuitive. The risk of falling down is higher for a one legged man than a two legged man than a four legged man and so on (obviously we’re stretching the definition of man pretty hard right now but you get the point). 

Now, lets walk through some cases and benefits of diversification, and why it’s necessary.  Let’s begin with you. If you have a job, and that is your only source of income, you’ll have a pretty hard time if you ever get fired. So that risk is always hovering. You’re like a business with one customer. By taking part of your savings and putting it into investments that earn some income, you’ve started diversifying. If you get to the point where no single income source can block your cash flow, you’re in a good place. 

Now, once you start investing you’re likely to buy equities. If you’re young there’s not much harm in having an equity heavy investment portfolio but once you’re established you probably want to diversify into real estate because during economic downturns, equities get hammered while real estate holds its value a lot better (except of course when it doesn’t like in 2008). 

Even with your equity portfolio, you don’t want to sit with more than 60% of your holdings in one sector or even worse, one stock. You want to spread your money around strategically across sectors, growth vs value stocks, dividend and blue chips, large vs small cap. Or do the best thing I always recommend for those who want to actually grow money over time, not just play around for years with no returns to show for it: buy a low cost, broad market index from Vanguard and let them do the work for you. Or go the automated route and use Betterment or Wealthfront to get largely the same results with less work.

Now, Let’s say at some point you start a business and it becomes successful. You should almost as a matter of course start shifting your liquid investments more heavily into real estate and hard assets since equities, represented by your stake in your business, will start to represent a bigger and bigger chunk of your net worth the bigger your business gets. Again, the risk is that if your business fails, or the economy takes a hit, the paper wealth in form of equity will evaporate faster than rental income and the intrinsic value of your real estate holding will, and take far longer to rebuild.
For someone in Nigeria with the macroeconomic and political risks we have, holding part of your investments abroad makes sense. So does holding some liquid assets in dollars to hedge against inflation. Multinationals do it all the time. 

For those in the US, who have enough money for it to make sense, gold reserves is another good inflation hedge. 

Spreading your investments across multiple countries and currencies is also a good way to diversify. Interactive Brokers is a good tool for this, if you have enough money and are holding assets directly. Vanguard does the job for the rest of us mere mortals. 

Finally if your net worth is $5m and above you probably need to sit down with someone knowledgeable and work out a more customized portfolio that includes fixed income, international stocks, bonds, real estate trusts and master limited partnerships. In this Case, you want to play both good offense and even better defense and generic answers no longer apply to you. 

That’s all I have on the subject. The actual mechanics of creating a diversified portfolio includes numbers, percentages and optimization but that’s not why we’re here. 

 

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