The Importance of Diversification in Mitigating Investment Risk

The Importance of Diversification in Mitigating Investment Risk

A key aspect of wise investment — whether personal or institutional — is diversification. Many people do not have a deep understanding of why diversification is so important. Diversification reduces the inherent risk of a given portfolio. For example, consider a large portfolio that only consists of stocks. When the economy weakens, corporate profits start to drop, and stock prices fall sharply. As a result, investors can lose a great deal of money. According to financial planners, wise investors may want to consider diversifying their portfolios so as to minimize losses caused by a drop in the stock market. Bonds and stocks tend to move in the opposite direction, so many investors use them to reduce risk. Since bonds do not yield high returns, casual investors with a large threshold for risk may want to pass on them, financial planners say.

diversificationIn economics, it is important to consider cause and effect. When prices fall, large banks tend to reduce the interest rates on their loans and remove some of the traditional barriers to borrowing. The actions stimulate increased corporate borrowing, which in turn causes bond prices to rise. Thus, bonds are a great way to diversify portfolios that consist primarily of stocks. While these investments produce minimal returns, they help maintain the value of a portfolio in times of economic turbulence.

World events and changes in the economy, ranging from interest rate hikes to reductions in exchange rates, have varied effects on different investment vehicles. In reality, not all investment platforms perform well at the same time. In a sense, diversification means accepting the fact that not all assets will be high performing to safeguard against losing all of one’s money should a particular investment lose value. When done correctly, diversification significantly reduces risk without reducing the average return on investment. For that reason, having an undiversified portfolio is simply an unnecessary risk to take.

The Two Primary Methods of Diversification

The diversification discussed in the first paragraph is across asset classes. Since asset classes perform differently in various market conditions, it is important to represent more than one in a portfolio. Three primary asset classes exist in the modern market. The first is cash and related equities, which can include money market funds, guaranteed investment certificates, and even traditional savings accounts. The second is fixed-income investments, such as bonds. This category also includes some mutual funds and exchange-traded funds that have a fixed-income payout. The third asset class is equities, the most popular examples of which is stocks. However, the asset class also encompasses most mutual funds and exchange-traded funds. Many investors also include real estate in their portfolios, whether through direct ownership or real estate investment trusts (REITs).

mortgageEach of these asset classes has a different risk profile. While individuals may think that cash assets have the least risk involved, investors need to think about variable interest rates, especially when compared to rates of inflation. In other words, the returns on these assets may not keep up with inflation so that investors actually lose money. However, these assets are protected by federal law. Similarly, fixed-income assets may be protected under federal law, but the interest rate may not outpace inflation and the duration of a bond may affect its ability to generate income. The creditworthiness of the issuer may also come into question. When it comes to stocks and other equities, investors need to understand the various tax implications of these holdings and pay attention to the performance of the market in general, as well as the specific industry. The holdings have the greatest risk and also the greatest growth potential. The real estate market is not tied to the stock market, so it can prove a wise investment choice, but some assets require dealing with tenants and their ability to pay. In addition, the capital gains and losses from sales can have a major effect on taxes.

While diversifying across assets is important, people must also diversify within assets, according to financial planners. To reduce the risks incurred by stocks, investors may want to choose stocks that do not have linked prices. Thus, the variations in one stock’s price may offset variations in another. Since stocks within a given industry tend to move together, investors must choose a variety of industries, financial planners say. Holdings in communications companies, financial services providers, and health care entities are not likely to all fall at once. Investors may also want to think about diversification within a particular industry. For example, within the energy industry, it could be wise to invest in both a solar company and an oil company. When one stock decreases in value, the other is likely to increase.

The Limits of Diversification

Diversification mitigates risk under normal market conditions and provides reasonable protection for an investor’s portfolio. However, investors need to understand that there is still risk involved in the investment process and that diversification has its limits. The prices of different assets generally do not move together, which is what makes diversification work. However, it is possible that this happens in a more volatile market. As market conditions become more extreme, the protections provided by diversification lessen. Typically, markets only become extreme in response to a major stimulus, such as a government default or market crash. In these situations, all asset classes tend to decline in value.