Diversification of Investments

Diversification is a technique that attempts to reduce risk by investing among various financial instruments, industries, etc. Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk.

Different Types of Risk

There are two main types of risk that investors must confront:

1) Un-diversifiable – also known as systematic or market risk, this risk is associated with every investment in varying degrees. Causes are things like inflation rates, economic instability, political instability, and changes to interest rates. Though this type of risk will be different for each asset class, it is not specific to a particular company and/or industry and it cannot be eliminated through diversification; it must be accepted by the investor.

2) Diversifiable – also known as unsystematic risk, this is risk that is specific to a company, an industry, a market, economy, or country, and it can be reduced through diversification. The most common sources of diversifiable risk are company or business risk and financial risk. The aim is to invest in various assets so that your investments are not all affected the same way by market events.

Why You Should Diversify Your Equity Portfolio

Let’s say that investor X has a portfolio of only airline stocks: if it were publicly announced that airline pilots are going on an indefinite strike and that all flights are cancelled, share prices of airline stocks would drop. Investor X’s portfolio would witness a noticeable drop in value. If, however, investor X had counter balanced the airline-industry stocks with railway stocks, only part of the portfolio would be affected. In fact, there is a good chance that the railway stocks’ price would climb if passengers turn to trains as an alternative form of transportation.

To take this a step further, there are many risks that affect both rail and air because each is involved in transportation. Any event that reduces travel hurts both companies (strong correlation). A superior way of diversifying is to diversify among companies in different industries. The more uncorrelated two stocks are, the greater the diversification. Mutual funds and ETFs provide an excellent opportunity for average investors to diversify their portfolios.

Asset Allocation Strategy

Another type of diversification is that of different asset classes. Because the prices of different asset classes (i.e. bonds and stocks) will not each react in the same way to adverse events, a combination of different asset types will reduce the portfolio’s decline during market swings. Generally, the bond and equity markets move in opposite directions, so, if your portfolio is diversified across both areas, unpleasant movements in one will be offset by positive results in another. Setting asset allocation targets and adjusting the portfolio during market ups and downs can help reduce risk and increase returns by taking advantage of market opportunities, often referred to as “buy low, sell high”.

Mutual funds and ETFs provide an excellent opportunity for average investors to diversify the asset classes in their portfolios.

Bottom Line

Diversification can help an investor manage risk and reduce volatility. Remember though, no matter how diversified your portfolio is, investment risk can never be eliminated, only reduced.

The key is to find your own comfort zone for risk and return; this will help ensure that your investments are suitable for you and your financial goals are realistic.