Diversification is an approach that reduces risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximize return by investing in different areas that would each react differently to the same event. Diversification is also knows as selecting assets which are uncorrelated, an example of this in the property world of investing, would be the difference in Hotel vs traditional residential investments.
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:
- Undiversifiable – Also known as “systematic” or “market risk,” undiversifiable risk is associated with every company. Common causes are things like 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 that investors must accept.
- Diversifiable – This risk is also known as “unsystematic risk,” and it is specific to a company, industry, market, economy, or country; it can be reduced through diversification. The most common sources of unsystematic risk are business risk and financial risk. Thus, the aim is to invest in various assets so that they will not all be affected the same way by market events. As in the above example, if your portfolio consisted of both a hotel investment plus a traditional residential property, and the housing market suffered a crash, you would not feel the direct effects of a housing market crash in your hotel investment, because they exist on totally different market fundamentals – and vice versa if the hotel market suffered a major correction. You are not immunising yourself to risk, more that you are mitigating the risk of uncorrelated assets within your portfolio from suffering losses also.
Why You Should Diversify
Let’s say you have a portfolio of only airline stocks. If it is publicly announced that airline pilots are going on an indefinite strike, and that all flights are cancelled, share prices of airline stocks will drop. Your portfolio will experience a noticeable drop in value.
If, however, you counterbalanced the airline industry stocks with a couple of railway stocks, only part of your portfolio would be affected. In fact, there is a good chance that the railway stock prices would climb, as passengers turn to trains as an alternative form of transportation.
But, you could diversify even further because there are many risks that affect both rail and air because each is involved in transportation. An event that reduces any form of travel hurts both types of companies. Statisticians, for example, would say that rail and air stocks have a strong correlation.
Therefore, you would want to diversify across the board, not only different types of companies, but also different types of industries and investment classes altogether, such as property investments, the more uncorrelated your portfolio is, the better.
It’s also important that you diversify among different asset classes. Different assets – such as bonds/Loan Notes and stocks – will not react in the same way to adverse events. A combination of asset classes will reduce your portfolio’s sensitivity to market swings. Generally, 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. The same is true for property investment, different types of property classes react differently to market changes. For example, whilst student accommodation may thrive during a housing market crisis, a portfolio of only buy to let would see you licking your wounds and counting how much equity has dropped out of each value.
There are additional types of diversification, and many synthetic investment products have been created to accommodate investors’ risk tolerance levels. However, these products can be very complicated and are not meant to be created by beginner or small investors. For those who have less investment experience, and do not have the financial backing to enter into hedging activities, bonds and loan notes are the most popular way to diversify against the stock market.
Unfortunately, even the best analysis of a company and its financial statements cannot guarantee that it won’t be a losing investment. Diversification won’t prevent a loss, but it can reduce the impact of fraud and bad information on your portfolio.
The Bottom Line
Diversification can help an investor manage risk and reduce the volatility of an asset’s price movements. Remember, however, that no matter how diversified your portfolio is, risk can never be eliminated completely.
You can reduce risk associated with individual investments, but general market risks affect nearly every investment in some form or another, and so it is also important to diversify among different asset classes. The key is to find a happy medium between risk and return; this ensures that you can achieve your financial goals while still getting a good night’s rest.