Most financial advisors and investment professionals agree that diversification is the most important factor in minimizing risk or the chance of loss in the stock market. Diversification is the practice of allocating investments among various equities and other financial instruments so that each reacts differently to a single event.
Diversification is not a guarantee, of course. Investing offers no guarantees. The goal is to minimize risk. The degree to which you minimize risk depends on your risk tolerance. Remember, the more you minimize risk, the lower the potential return on your investment.
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Different Types of Risk
There exist two main types of risk. One is called undiversifiable, also known as "systematic" or "market risk." Undiversifiable risk is associated with every potential investment and cannot be eliminated or reduced through diversification. Undiversifiable risk is caused by things like inflation, exchange rates, political instability, war and even interest rates.
The second type of risk is known as diversifiable or "unsystematic risk." It is specific to the company, industry, sector, economy or country in which a company operates. It can be reduced through diversification. Most unsystemic risk relates to business risk or financial risk. By investing in various assets that will not all be affected the same way by events related to business risk or financial risk you can mitigate risk through diversification.
Why You Should Diversify
Suppose your portfolio consisted only of restaurant stocks. If the restaurant industry was hit hard by food prices, a truck strike or economic factors that stopped people from eating in restaurants, your portfolio could be in trouble.
If you also had stocks in other sectors that counter-balanced the restaurant industry, those stocks might flourish while your restaurant stocks recovered. To diversify properly you need to understand each sector in which you invest, including how those sectors interact. If they closely interact, such as the trucking industry and the restaurant industry, your diversification might fail to have the desired effect.
Diversify By Asset Class
Not only do you want your diversification to reflect different sectors, you also want to diversify by investing in different asset classes – such as bonds and stocks. For example, bonds and equities (stocks) tend to move in different directions. Negative movements in one asset class might be offset by positive moves in the other.
There are other ways to diversify by asset class other than stocks and bonds, but they can become very complicated and are not for beginners. Some, like hedge funds, require enormous amounts of capital and are not available to many individual investors.
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Two Mistakes You Could Make
It’s important to avoid making mistakes when attempting diversification. Having more than 20 or 30 securities in a portfolio is a mistake often made by investors who think “more is better.” The problem is things can easily become so complicated you can’t keep track or fees swallow up any upside.
Another mistake involves an attempt to perfectly balance the upside and downside of two assets. If it were possible (it isn’t) you would end up making nothing because the upside of one asset would be canceled by the downside of the other.