How Diversification Reduces Risk

Watch our video that explains how diversification reduces risk here.

Undiversifiable vs. Diversifiable Risk

There are generally two types of risk in investing. Undiversifiable risk, otherwise known as systematic risk, is part of every company and industry. Inflation rates, the political climate, interest rates, war, and other risk that cannot be mitigated in any way falls into this category. Diversifiable risk, on the other hand, is directly related to each individual company and market and can be reduced through diversifying. Business risk and financial risk are different for each asset. If you invest in various assets, therefore, they will not be affected the same way by events in the market.

Smart Diversification

Investing everything in one industry is generally a poor strategy. If that industry is affected negatively by a market event, your entire portfolio suffers (for example, the dotcom, real estate, commodity, gold, oil and financial bubbles of just the past two decades). To diversify smartly, you need to invest in a wide variety of industries, companies, and asset classes. The more uncorrelated your investments, the better. That way, they should weather market events differently. Ideally, this will protect your wealth.

Diversification May Mean Earning More Slowly

Taking risk sometimes means getting great rewards. Typically, however, investors have to do this by consciously choosing not to diversify. If one industry soars, it’ll make a great return (such as with technology in the 1990s). If it crashes, however, their wealth crashes too (Technology in 2000-2003 had losses in the -70% range.). When you choose to diversify, you may not experience those huge gains and drops, but your investment portfolio should remain more stable, bringing you a decent return without the volatility. Through diversification, you will not maximize your returns, by any means. However, your portfolio will better stand up to the rise and fall of the market over time. Your long-term earnings will make your caution worthwhile.

Diversification Can’t Destroy Risk

As with any market strategy, diversification cannot completely destroy risk. While it can certainly do a great job of mitigation, there will always be some risk in investments, diversified or not. Your financial advisor can help you determine what level of risk is acceptable to you, and tailor your portfolio to meet that tolerance (we suggest you let the financial planning process help guide these decisions).

Considerations in Diversification

It is important to diversify in various asset classes to best maximize on what diversification can do for you. Typically, when one asset class is doing poorly, another may be doing well. Mix up your investments between regions, too. A blend of foreign and national investments is typically an ideal way to spread out your risk. With all of this in mind, be aware that too much of a good thing can actually be bad. Investors should be careful not to invest in too many assets in the name of diversification. Even with a financial advisor on board, it can be complicated to juggle a lot of investments. Spread out your wealth across various sectors and industries, and asset classes, but keep it to a reasonable number.

What Can a Financial Advisor Do?

Aside from helping you tailor your portfolio to your risk tolerance, a financial advisor can do a lot to help you diversify. Risk tolerance is not the only consideration when setting up your investments. You also need to factor in the timeline of your goals. If you want money fast, or are willing to wait it out in the long term, it will affect how your investments should be structured. Your financial advisor can weigh both of these factors to create a diversification strategy that is unique to you. Evidence-based strategies using logic and knowledge rather than emotion usually do well.

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