Managing Risk, Diversification

A strategy used by investors to manage risk. By spreading your money across different assets and sectors, the thinking is that if one area experiences turbulence, the others should balance it out. It’s the opposite of placing all your eggs in one basket.

Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event.

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. Here, we look at why this is true and how to accomplish diversification in your portfolio.

Different Types of Risk

Investors confront two main types of risk when investing. The first is undiversifiable, which is also known as systematic or market risk. This type of risk is associated with every company. Common causes include inflation rates, exchange

rates, political instability, war, and interest rates. This type of risk is not specific to a particular company or industry, and it cannot be eliminated or reduced through diversification it is just a risk investor must accept.

Systematic risk affects the market in its entirety, not just one particular investment vehicle or industry.

The second type of risk is diversifiable. This risk is also known as unsystematic risk and is specific to a company, industry, market, economy, or country. It can be reduced through diversification. The most common sources of unsystematic risk are a business risk and financial risk. Thus, the aim is to invest in various assets so they will not all be affected the same way by market events.

Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk. The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.

Diversification strives to smooth out unsystematic risk events in a portfolio, so the positive performance of some investments neutralizes the negative performance of others. The benefits of diversification hold only if the securities in the portfolio are not perfectly correlated that is, they respond differently, often in opposing ways, to market influences.

• Diversification reduces risk by investing in investments that span different financial instruments, industries, and other categories.
• Risk can be both undiversifiable or systemic, and diversifiable or unsystemic.
• Investors may find balancing a diversified portfolio complicated and expensive, and it may come with lower rewards because the risk is mitigated.

Diversification by Asset Class

Fund managers and investors often diversify their investments across asset classes and determine what percentages of the portfolio to allocate to each. Classes can include:

• Stocks: Shares or equity in a publicly traded company
• Bonds: Government and corporate fixed-income debt instruments
• Real estate: Land, buildings, natural resources, agriculture, livestock, and water and mineral deposits
• Exchange-traded funds (ETFs): A marketable basket of securities that follow an index, commodity, or sector
• Commodities: Basic goods necessary for the production of other products or services
• Cash and short-term cash-equivalents (CCE): Treasury bills, certificate of deposit (CD), money market vehicles, and other short-term, low-risk investments