Diversification is the best way to reduce portfolio risk. It has long been understood that spreading your capital wisely can save you from unexpected asset deterioration, but exactly how to do that needs to be reconsidered.

There are a host of new products available to individual investors. Traditionally, people have been told that buying stocks and bonds is good enough to build a diversified portfolio. Still others, who really think they’re savvy, spread their bets into small, mid, and large cap stocks. These people may even buy variable maturity debt securities, such as long and short term Treasuries or municipal bonds. While these techniques are a good start, the modern investor should use all the tools at their disposal, not just what worked in the past.

With the emergence of exchange-traded funds (ETF’s) there has sprung forth tremendous new tools for diversifying individual portfolios. Stocks and bonds can now be supplemented by precious metals, natural gas, oil, agricultural commodities, real estate, sub sectors of the economy (retail, financials, energy, etc.), targeted global markets, and currencies.

A great way for American investors to hedge inflation and the decline of the dollar is to purchase currency ETF’s. These instruments enable investors to gain exposure to specific foreign currencies, which are often uncorrelated to US stocks and bonds.

Negatively correlated assets held in the same portfolio reduce overall risk. Risk, as measured by variance of returns, can actually be lowered simply by holding assets that do not move in the same direction. For instance, if stock A decreases 70% of the time stock B increases, and vice versus, then you could construct a portfolio that has less total risk than either A or B by including both.

Someone holding predominantly US stocks in their portfolio should consider adding currencies that are negatively correlated. It turns out that Swiss Franc, Japanese Yen, and Swedish Krona move in opposite directions as US stocks, while Australian dollar, Mexican Peso, and Canadian dollar move in the same direction.

Including the negatively correlated currencies over the last year would have seen between 12% and 17% capital gains. This is due merely to appreciation relative to the US dollar. In addition to relative currency gains, each ETF offers dividends representative of each countries interest rates.

An income investor should consider holding Mexican Peso, Australian Dollar, and British Pound, while avoiding Yen and Swiss Franc. There are many factors to take into consideration, but applying basic portfolio theory to your own holdings can have signficant long term results.

Currency ETF’s offer a great alternative to traditional methods of diversification and are great to offset further declines in our own currency. Consider that commodities price growth is largely attributable to US dollar depreciation and you can see how foreign currencies can insulate individuals from energy, food, and other commodity-driven inflation.

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This entry was posted on Tuesday, August 12th, 2008 at 6:41 pm and is filed under Investing. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.