How to Reduce Your Investment Risk Through Diversification
Every investment portfolio is exposed to two types of risks, namely the Systematic Risk and the Individual Stock Risk.
The Systematic Risk is essentially an inherent market risk spawned by the market’s volatility, and affects the whole financial market on the macro level or an entire segment of the market.
Since the measure of a stock’s volatility in relation to the market is known as beta, this particular market risk has also become known as such. A good example of this macro level threat is recession where the ensuing economic downturn has a negative impact on the entire stock market.
This particular risk cannot be reduced, much less relieved through diversification. The only way to mitigate this risk is through a well calculated asset allocation strategy or through hedging.
The Individual Stock Risk is a stock-specific risk that refers to the possibility that a particular stock may perform below market expectations because of some internal issues such as the company goofing on an important business decision or a well-publicized business undertaking. The particular blunder may negatively impact the value of their stocks in the market, causing it to decline while the rest of the equities market continues to rise. This type of risk can be mitigated through diversification or by simply holding a diverse collection of different equities.
Diversification is choosing dissimilar investments in an effort at increasing returns and reducing overall portfolio risk. While it is tempting to put all of your eggs into one basket in the hopes of striking it rich, this action can also lead to financial ruin as employees of Enron and WorldCom experienced.
Since no amateur or professional can forecast the future of the stock market, we are better off buying the entire market through a low-cost index fund. This provides instant exposure to every winner and every loser; thankfully, the gains from the winners have outpaced the losses of the failures.
The easiest way to achieve instant diversification from company risk is through a mutual fund. The S&P 500 index contains the stocks of 500 large-cap American companies. By investing in a mutual fund, you eliminate the chance that one company will wipe you out; however, is this enough?
A mistake that many investors made in the latest financial meltdown was assuming they were diversified because they held several large-cap index funds. When the market plunged, so did every fund they held. A more prudent strategy is to include asset classes with low correlations to one another.
Additional asset classes which investors may want to consider include international funds, real estate investment trusts, bond funds, and small cap funds. An investor who put 100% of their assets into an S&P 500 fund in the year 2008 saw the value of their account plunge by nearly 50%. However, an investor who invested 50% in an S&P 500 fund and 50% in a total bond market fund experienced a roughly 25% drop in his or her portfolio. Also, they had the opportunity to pick up shares dirt cheap by selling a portion of their bonds during the worst drop since the Great Depression.
Diversification allows investors to invest across a wide spectrum of asset classes which reduce overall risk and increase total return. The investor will experience fewer sleepless nights and less stomach acid compared to those less diversified.
Brokerage houses offer more selections at lower costs than ever before. It has never been easier to construct a well-diversified and low-cost portfolio than it is today. Consider adding index funds or ETF’s focused on international markets, real estate investment trusts, or bonds. Through a well-diversified portfolio, you will increase the likelihood of reaching your financial goals while reducing the chance of financial ruin.
So far, we are aware of two different techniques to mitigate certain portfolio risks. We know that individual stock risks can be reduced through diversification. We also know that systematic risks can only be lowered through hedging. There is actually just a fine line that differentiates these two techniques and it is worth discussing further so we will have a better grasp of what diversification is really all about.
The idea behind diversification is to create an investment portfolio with multiple assets in order to lower the risk. Generally, the higher the number of assets that are in a portfolio, the lower the risk of the portfolio becomes. For example, if you have twenty different equities in your portfolio, and one or two of them are underperforming due to some management blunder, the rest of your holdings will remain unaffected. They will continue to generate earnings for you, mitigating the loss of the underperforming stocks in the process.
Now, if you park all your money in a single asset instead of distributing it among a basket of different assets, you are practically courting disaster. If, for some specific company blunder, the value of its stocks takes a nose dive, then your whole investment goes under with it.
Hedging, on the other hand, is about mitigating the systematic risk on an investment portfolio. It involves including two different assets that are negatively correlated to each other in the same portfolio to reduce the risk. It means whatever negative developments one of the assets goes through will be positive to the other.
A classic example of this is the negative correlation between the two different assets gold and equities. During times of severe political upheaval or economic crisis such as global recession, the price of equities takes a nose dive while the price of gold typically shoots up. This is the reason why gold is considered a safe haven for investible funds during times of crisis.
Diversification smoothens the overall performance of an investment portfolio by offsetting the negative results of a few underperforming assets with the positive gains resulting from the solid performance of the rest of the assets in the portfolio. There is a catch, though. You end up losing some of the potential gains made by your performing assets. This, however, is a fair enough trade-off since you will be reducing the overall risks your portfolio is exposed to.
Just imagine if you had placed all of your investments in a single asset that is severely underperforming. You are likely to lose most if not all of your investments. If you diversify, you may lose some of the potential gains but you will be giving your portfolio greater stability to weather volatile markets.
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