Thursday, May 29, 2008

Diversification and Compounding Effect

After writing about Anne Scheiber last week, it inspired me to write about Diversification and Compounding today.

Diversification is very powerful strategy because it reduces the various types of investment risks that are present in any portfolio. By allocating your assets among different asset classes and sectors, gains in one part of the fund can lessen or even eliminate the impact of losses in another fund.
With occasional rebalancing, the returns will be better.

An illustration to show you the power of compounding and diversifcation

Scenerio A
Mr Tan invested $100,000 into a fund that returns 5% over 20 years
Eventual returns = $265,330

Scenerio B
Mr Tan invested $100,000 equally into 5 funds that returns 0%, 2.5%, 5%, 7.5% and 10%
Fund 1 @ 0% = $0
Fund 2 @ 2.5% = $32,772
Fund 3 @ 5% = $53,065
Fund 4 @ 7.5% = $84,957
Fund 5 @ 10% = $134,550
Eventual Returns = $305,344

In the above example, I had used an extreme case whereby Mr Tan lost 100% in one of his fund which is nearly impossible. You may also question me if there is a fund that can potentially returns 10%p.a, why not? S&P had returned nearly 11%p.a over the past 30 years.

1. Diversification correctly help you to reduce your risk
2. Diversification correctly help you to improve your returns
3. Diversification correctly improve your liquidity
4. Diversification with correct rebalancing boost your returns
5. Diversification, Compounding and Rebalancing with adequate time horizon can be your preferred strategy... provided you do it right...

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