DIVERSIFICATION is a technique that lowers risk by allocating investments among a variety of financial instruments, industries and other categories. It aims to maximise returns by investing in different areas that would each respond differently to the same event.

Diversification is the most important factor of reaching long-range financial goals, as most investment professionals will agree that it will minimise risk but is no guarantee against loss. Today, we examine why this is true, and how to achieve diversification in your portfolio.

When investing, the two main types of risk investors face are undiversifiable risk and diversifiable risk.

Undiversifiable risk, also known as ‘systematic’ or ‘market risk’, is risk associated with every company. Inflation rates, exchange rates, political instability, war and interest rates (monetary policy) are all causes for this kind of risk. It is not specific to a particular company or industry, and it cannot be eliminated, or reduced, through diversification; it is just a risk that investors must accept.

Diversifiable risk, also known as ‘unsystematic risk’, is specific to a company, industry, market, economy or country and can be reduced through diversification. The most common sources of unsystematic risk are financial risk and business risk. The goal is to invest in various assets so that they will not all be affected the same way by market events.

Imagine if you had a portfolio of only airline stocks and a public announcement was made that airline pilots were going on an indefinite strike, flights would be cancelled and the share prices of airline stocks were likely to fall. This would likely lead to your portfolio experiencing a noticeable drop in value. However, had you counterbalanced the airline industry stocks with a couple of railway stocks, it might only impact part of your portfolio. There is also a chance that the railway stock prices would increase, as passengers turn to trains as another form of transportation.

An individual could diversify even more because there are many risks that could affect both air and railway, because each is involved in transport. An event that reduces any form of travel could hurt both types of companies. Statisticians would say that rail and air stocks have a strong correlation. Thus, to attain superior diversification, you would want to diversify across the board, not only different types of companies but industries as well. The less correlated your stocks are, the better, in the event of adverse circumstances.

An individual should also vary across the different asset classes, in line with their risk tolerance and investment policy statement. Assets such as bonds and stocks tend to have different reactions to adverse events. Therefore a combination of asset classes is likely to lessen your portfolio’s sensitivity to market changes.

Generally, the bond and equity markets move in opposite directions, so, if your portfolio is diversified across both areas, negative movements in one will be equalised by positive results in another.

There are other types of diversification, and many artificial investment products have been created to accommodate investors’ risk tolerance levels. These products can be very complex and are not meant to be created for beginner or small investors. For those who have less investment experience, and do not have the financial support to enter into hedging activities, the most popular way to diversify against the stock market are bonds.

There is no guarantee that any investment won’t be a losing one even with the best analysis of a company and its financial statements. You can’t prevent a loss, but you can reduce the impact of bad information and irrational market movements on your portfolio through diversification.

Owning five stocks is usually better than owning one — but eventually adding more stocks to your portfolio won’t make a difference. There is much discussion over how many stocks are needed to reduce risk while maintaining a high return. The most conventional view argues that an investor can achieve optimal diversification with only 15 to 20 stocks spread across various industries.

Diversification can help an investor manage their risk and reduce the volatility of an asset’s price movements. It is important to remember that no matter how diversified your portfolio is, risk can never be completely eliminated. You can reduce risk associated with choices in individual stocks, but general market risks affect nearly every stock, so it is important to diversify among various asset classes.

The key is to find a balance between potential risk and return; this ensures that you achieve your financial goals while still being able to sleep peacefully at night.

All of this should be in line with one’s tolerance for risk and final goals, and requires the assistance of an experienced professional. For help in creating your investment portfolio speak with a licensed financial advisor.

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