I’m sure you’ve heard this saying, “Don’t put all your eggs in one basket.” There is a good reason for this popular idiom, and it has to do with your ability to safely manage your exposure to risk in your investment portfolio.
Last month, we shared an article, Understanding Risk, in which we uncovered what investor risk is, how to understand your own tolerance for risk, and some self-disciplines that can help you manage your risk appropriately. Now, let’s explore how diversification plays a major role in helping you mitigate risk while still taking advantage of market performance.
What Is Diversification?
The idea is simple, you want to limit your downside risk, or the amount of money you could lose, by having an investment portfolio that owns different asset classes like stocks, bonds, real estate and cash. You do not want to be concentrated in any single asset class. (For related reading, see: Diversification: It's All About (Asset) Class.)
How Does Diversification Work?
Diversification works to protect your investments against the downside while still taking advantage of the upside, because when one asset goes up, another goes down and another stays the same.
Keep in mind that being diversified means you won’t hit the home run. However, and perhaps more importantly, you won’t strike out either, which you have a much greater probability of doing. According to the JP Morgan Report "The Agony and the Ecstasy: The Risks and Rewards of a Concentrated Stock Position," the odds of you picking the next Apple is around 7%, while the odds of you picking the next Pets.com is around 40%.
Diversification can help make a bumpy ride a lot smoother for you as you journey toward your investment goals. Generally speaking, when stocks go up in value, bonds tend to go down in value. These two asset classes moving in opposite directions help stabilize an investment portfolio when both are present.
What Is Market Volatility?
The continual fluctuation in the stock market is called volatility. It refers to the amount of risk associated with the value of stocks.
A higher volatility will mean that a stock’s value can change dramatically over a short time period in either direction. When high volatility is present, you will notice frequent peaks and valleys on an investment chart, as was the case after the financial crisis of 2008 when markets bounced along the bottom before gradually trending upward again. (For related reading, see: Volatility's Impact on Market Returns.)
A lower volatility will mean that a stock's value does not fluctuate dramatically, but simply changes in value steadily over a period of time. Low volatility indicates greater market stability. In either case, diversification is a helpful strategy for investors so that you don’t ride the roller coaster of a volatile market cycle and can still see favorable returns in a less volatile market cycle.
How Can You Measure Your Risk?
There are different types of risk. You can bet the farm in stocks and lose it all. You can invest some of your money in underperforming stocks, but your overall portfolio doesn’t lose money because you are properly diversified in other asset classes.
As I have established in my previous post, high risk carries the potential for the highest reward and also the highest loss. Moderate risk combines higher risk investments with lower risk investments to more evenly balance out an investor’s performance over the long-term. (For related reading, see: Measuring Portfolio Risk.)
One way to get a handle on the various levels of risk is to measure it. In the world of investing, the risk of an investment is measured by how far it deviates from an expected outcome. For you reading this article, you are not going to measure standard deviations. Instead, think of your portfolio in broadly based categories like low, moderate, and high risk.
- If all of your investments are in only a few singles stocks, you have a high level of risk.
- If your investments are 60% in stocks and 40% in bonds and globally diversified across asset classes, you have more of a moderate level of risk.
- If the majority of your assets are in short-term, high-quality bonds and cash, you have a low level of risk.
How Can You Leverage Diversification?
Once you have better understanding of the level of risk and diversification in your investments, you can start thinking about how that aligns with your risk tolerance and capacity. Are they aligned?
It is when you have clearly outlined your capacity for risk within the same context of your short-term and long-term financial goals that you can truly develop a diversification strategy that makes the most sense for you.
(For more from this author, see: 4 Steps to Help You Build Wealth Right Now.)
To learn more about working with a financial advisor, you can download the free guide, "The Ultimate Guide for Choosing Financial Advice."