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Diversifying your portfolio: What it is and why it's important

At a glance:

  • What is diversification?

  • Unsystematic and systematic risks

  • Diversification across companies

  • Diversification across asset classes

  • The pros and cons of diversification

  • Summary of diversifying your portfolio

  • Practical ideas you can start with today

Avoiding risk is difficult no matter how you choose to invest. Most investors are aware that you must take greater risks to achieve higher returns.

However, no one wants to take more risk than necessary to achieve one's financial goals. Diversification helps reduce risk.

There are some risks investors take for which they expect to be rewarded. Other risks are so haphazard that they cannot be rewarded, nor should investors take them. It is the latter kind of risk that investors eliminate through diversification. Savvy investors don't take risks for which they don't get paid.

What is diversification?

Diversification means dividing your investments among a variety of assets. Diversification helps to reduce risk because different investments can rise and fall independently of each other. The combinations of these assets more often than not will cancel out each other's fluctuations, therefore reducing risk.

How can you diversify, and why?

There are many ways to diversify your investment portfolio. You can diversify across one type of asset classification—such as stocks. For example, you might purchase shares in the leading companies across many different (and unrelated) industries.

Alternatively, you can diversify your portfolio across different types of assets such as stocks, bonds, and real estate, for example. You can also diversify on the basis of regional decisions such as state, region, or country. Simply stated, diversification means "don't put all your eggs into one basket."

The ultimate goal of diversification is to improve performance while reducing investment risks. A well-diversified portfolio spreads risks over a range of investments whose performances are not tied to the performance of the other assets in the portfolio.

What are unsystematic and systematic risks?

All investments are subject to risk. It is generally believed that investors are rewarded for taking risk.

However, some risk is not rewarded. Investors need to control or eliminate risks for which they are not rewarded from their investment portfolio. Investment risks can be placed into two broad categories: unsystematic and systematic risks.

Unsystematic risk

Unsystematic risk (also called diversifiable risk) is risk that is specific to a company. This type of risk could include dramatic events such as a strike, a natural disaster such as a fire, or something as simple as slumping sales. Two common sources of unsystematic risk are business risk and financial risk.

Diversification and unsystematic risk

Diversification can greatly reduce unsystematic risk from a portfolio. It is unlikely that events such as the ones listed above would happen in every firm at the same time. Therefore, by diversifying, one can reduce their risk. There is no reward for taking on unneeded unsystematic risk.

Systematic risk

On the other hand, some events can affect all firms at the same time. Events such as inflation, war, and fluctuating interest rates influence the entire economy, not just a specific firm or industry.

Diversification cannot eliminate the risk of facing these events. Therefore, it is considered un-diversifiable risk. This type of risk accounts for most of the risk in a well-diversified portfolio. It is called systematic risk or market risk. However, the expected returns on their investments can reward investors for enduring systematic risks.

Investors are induced to take risks for potentially higher returns. However, not all risks offer such potential rewards. The wise investor identifies these risks and eliminates them from his or her portfolio through diversification.

Diversification across companies

Portfolio design is very important to effectively minimizing risk. When you invest, you can lose your money, although we don't recommend that. One of the best ways to protect against losing all your money is to diversify your portfolio. Diversification summarizes the adage "Don't put all your eggs into one basket."

If you invest in one company, and that company goes belly-up, you stand to lose your investment. If you invest in two companies, you reduce the chances of losing all your money to 50%.

But you do need to be careful. The risks inherent in an individual company are unsystematic risks, meaning that they apply only to that company. However, they may also apply to similar companies.

An example

It is important to consider how to reduce unsystematic risk if you want to create an effectively diversified portfolio. Let's say you work for a book publishing company and want to buy stock in your company. If you only buy shares of your company and it falls on hard times, you stand to lose money.

Since you know the book publishing industry, you decide to diversify and buy stock in several of your company's competitors as well.

However, some of the inherent risks of your company may also be inherent in the other companies in the book publishing industry. For example, what if all the book binders in the industry went on strike?

The effects of such an event could lead the prices of all publishing stocks in that industry to plummet. Your holdings in publishing companies would be left at a deflated level. In this case you failed to identify the inherent (unsystematic) risks of each of the companies in which you invested.

If you diversified across industries ...

However, if you also had holdings in other industries such as oil, consumer durables, and electronics, it is less likely that the unsystematic risks in the publishing industry would adversely affect your other holdings. What is more, unfortunate circumstances in the book publishing business might result in a boom in other industries.

The delays in the traditional print publishing business mentioned previously could cause people to publish materials in electronic form. If you held stock in an electronic publishing company, your stock might even benefit from the troubles that were slowing the growth of your holdings in the book publishing industry. Now you have diversified your portfolio, reducing the inherent risks of one or two companies and industries.

Specialists James Denaro, left, and Mario Picone work at a post on the floor of the New York Stock Exchange, Tuesday, March 12, 2019. Another slide in Boeing weighed on the Dow Jones Industrial Average. (AP Photo/Richard Drew)
Specialists James Denaro, left, and Mario Picone work at a post on the floor of the New York Stock Exchange. (Photo: AP Photo/Richard Drew)

Know risk inside and out

In order to effectively diversify your portfolio, you need to consider the inherent risks of the companies in which you invest and try to select different companies and different industries to help reduce the possibility that all will share the same fate together. Diversification can lower risk by spreading your investment over several companies and industries.

Diversification across asset classes

There are many ways one can invest. You can invest in stocks and become an owner of a corporation. You can invest in bonds and make a loan to a corporation. You can invest in a portfolio of securities such as mutual funds or exchange-traded funds.

Different investments may be classified by the type of investment or even the objectives of a portfolio. Because there are many different classes of assets in which to invest, it is possible to diversify your portfolio based on asset class.

Why diversifying works

Diversification across asset classes provides a cushion against market tremors. This is because each asset class has different risks, rewards, and tolerance of economic events. By selecting investments from different asset classes, you can achieve lower portfolio risk and volatility in portfolio value.

Negative correlation

Investments whose price movements tend to be opposite each other are negatively correlated. For example, if a bond's price rises when certain stock prices fall, these two classes are negatively correlated. When negatively correlated assets are combined within a portfolio, the portfolio volatility is reduced.

This is easy to understand: as one price goes up and the other down, the average of the two will not be as high or low as either of the asset's prices. An average is always less volatile than its components.

The importance of choosing a variety of assets

It is not always possible to know the precise correlation of one asset class to another. However, financial planners often recommend that you have different asset classes in your portfolio. For example, you might include cash (or equivalents), stocks or stock mutual funds, bonds or bond mutual funds, real estate, etc. It is generally accepted that such broad classes of assets help reduce portfolio volatility.

If you are able to identify your investments' correlations, then you can go the next step, which is asset allocation to build an efficient portfolio. Remember though, even by diversifying and following an asset allocation model will not assure a profit or protect against loss.

Diversification across asset classes is another way to help reduce portfolio risk. It can help improve your potential for investment success.

The pros and cons of diversification

Diversification can help reduce risk from an investment portfolio by eliminating unsystematic risk from the portfolio. By choosing securities of different companies in different industries, you can lower the risks associated with a particular company's "bad luck." By diversifying among asset classes that are negatively or weakly correlated (i.e., whose up or down price movements don't mirror each other), you can further reduce the volatility of your portfolio.

The downside of diversifying

However, diversification can reduce the return of your portfolio as well. By selecting several assets, the overall return on your portfolio will be the weighted average of the returns of those assets. For example, let us look at a portfolio made up 50/50 of a single stock and a single bond. In one year, the stock has a total return of 30 percent, the bond 6 percent. The portfolio return will be only 18 percent (36 divided by 2). However, if the entire portfolio were invested in the stock, the return would have been 30 percent.

Weigh the pros and cons

Many investors feel that settling for a lower average return is a small price to pay for reducing risks for which they cannot be rewarded (unsystematic risk) from their portfolio. They might argue that if the stock in the example above tanked, then 3% would look pretty good. Of course, in practice these extremes, while possible, are rare.

Summary of diversifying your portfolio

Diversification reduces portfolio risk by eliminating unsystematic risk for which investors are not rewarded. Investors are rewarded for taking market risk. Because diversification averages the returns of the assets within the portfolio, it attenuates the potential highs and lows.

Diversification among companies, industries, and asset classes affords the investor the greatest protection against business risk, financial risk, and volatility. When they say, "Don't put all your eggs into one basket," they're talking diversification.

Ready to try your hand at some diversifying of your own?

Practical ideas you can start with today

  • Determine your risk tolerance.

  • Identify, perhaps with a financial advisor, a range of investment options suitable to your goals.

  • Create a diversified portfolio of investments that is likely to provide the greatest return in keeping with your risk tolerance.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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