The Importance Of Diversification

Diversification is a technique 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. 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. !ere, we look at why this is true, and how to accomplish
diversification in your portfolio. "#o learn more, see Diversification: Protecting Portfolios From Mass
Destruction.)
TUTORIAL: Risk and Diversification
Different Types of Risk
Investors confront two main types of risk when investing$
Undiversifiable %lso known as &systematic& or &market risk,& undiversifiable risk is
associated with every company. 'auses are things like inflation rates, exchange rates, political
instability, war and interest rates. #his type of risk is not specific to a particular company or
industry, and it cannot be eliminated, or reduced, through diversification( it is )ust a risk that
investors must accept.
Diversifiable #his 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. #he most
common sources of unsystematic risk are business risk and financial risk. #hus, the aim is to
invest in various assets so that they will not all be affected the same way by market events.
Why Yo !hold Diversify
*et+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 canceled, share prices of airline stocks will drop.
,our 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.
-ut, you could diversify even further because there are many risks that affect both rail and air, because
each is involved in transportation. %n event that reduces any form of travel hurts both types of
companies statisticians would say that rail and air stocks have a strong correlation. #herefore, to
achieve superior diversification, you would want to diversify across the board, not only different types
of companies but also different types of industries. #he more uncorrelated your stocks are, the better.
It+s also important that you diversify among different asset classes. Different assets such as bonds and
stocks will not react in the same way to adverse events. % combination of asset classes will reduce
your portfolio+s sensitivity to market swings. .enerally, the 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. "#o learn more about asset class, see Five Things To Know About
Asset Allocation.)
#here 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. /or those who have less investment
experience, and do not have the financial backing to enter into hedging activities, bonds are the most
popular way to diversify against the stock market.
0nfortunately, 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.
"o# $any !tocks Yo !hold "ave
1bviously owning five stocks is better than owning one, but there comes a point when adding more
stocks to your portfolio ceases to make a difference. #here is a debate over how many stocks are
needed to reduce risk while maintaining a high return. #he most conventional view argues that an
investor can achieve optimal diversification with only 23 to 45 stocks spread across various industries.
"#o learn more about what constitutes a properly diversified stock portfolio, see Over-Diversification
iel!s Diminishing "eturns. #o learn about how to determine what kind of asset mix is appropriate for
your risk tolerance, see Achieving O#timal Asset Allocation.6
%onclsion
Diversification can help an investor manage risk and reduce the volatility of an asset+s price
movements. 7emember though, that no matter how diversified your portfolio is, risk can never be
eliminated completely. ,ou can reduce risk associated with individual stocks, but general market risks
affect nearly every stock, so it is important to diversify also among different asset classes. #he key is to
find a medium between risk and return( this ensures that you achieve your financial goals while still
getting a good night+s rest.
& Thin's To (no# Abot Asset Allocation
8ith literally thousands of stocks, bonds and mutual funds to choose from, picking the right
investments can confuse even the most seasoned investor. !owever, starting to build a portfolio with
stock picking might be the wrong approach. Instead, you should start by deciding what mix of stocks,
bonds and mutual funds you want to hold this is referred to as your asset allocation.
What Is Asset Allocation)
%sset allocation is an investment portfolio technique that aims to balance risk and create diversification
by dividing assets among ma)or categories such as cash, bonds, stocks, real estate and derivatives. 9ach
asset class has different levels of return and risk, so each will behave differently over time. /or
instance, while one asset category increases in value, another may be decreasing or not increasing as
much. :ome critics see this balance as a settlement for mediocrity, but for most investors it+s the best
protection against a ma)or loss should things ever go amiss in one investment class or subclass.
#he consensus among most financial professionals is that asset allocation is one of the most important
decisions that investors make. In other words, your selection of stocks or bonds is secondary to the way
you allocate your assets to high and lowrisk stocks, to short and longterm bonds, and to cash on the
sidelines.
8e must emphasize that there is no simple formula that can find the right asset allocation for every
individual if there were, we certainly wouldn+t be able to explain it in one article. 8e can, however,
outline five points that we feel are important when thinking about asset allocation$
*+ Risk ,s+ Retrn
#he riskreturn tradeoff is at the core of what asset allocation is all about. It+s easy for everyone to say
that they want the highest possible return, but simply choosing the assets with the highest &potential&
"stocks and derivatives6 isn+t the answer. #he crashes of 2;4;, 2;<2, 2;<=, and the more recent declines
of 455=455; are all examples of times when investing in only stocks with the highest potential return
was not the most prudent plan of action. It+s time to face the truth$ every year your returns are going to
be beaten by another investor, mutual fund, pension plan, etc. 8hat separates greedy and returnhungry
investors from successful ones is the ability to weigh the difference between risk and return. ,es,
investors with a higher risk tolerance should allocate more money into stocks. -ut if you can+t keep
invested through the shortterm fluctuations of a bear market, you should cut your exposure to equities.
-+ Don.t Rely !olely on /inancial !oft#are or 0lanner !heets
/inancial planning software and survey sheets designed by financial advisors or investment firms can
be beneficial, but never rely solely on software or some predetermined plan. /or example, one old rule
of thumb that some advisors use to determine the proportion a person should allocate to stocks is to
subtract the person+s age from 255. In other words, if you+re >3, you should put ?3@ of your money
into stocks and the remaining >3@ into bonds, real estate and cash.
-ut standard worksheets sometimes don+t take into account other important information such as
whether or not you are a parent, retiree or spouse. 1ther times, these worksheets are based on a set of
simple questions that don+t capture your financial goals. 7emember, financial institutions love to peg
you into a standard plan not because it+s best for you, but because it+s easy for them. 7ules of thumb
and planner sheets can give people a rough guideline, but don+t get boxed into what they tell you.
1+ Determine Yor Lon'2 and !hort2Term 3oals
8e all have our goals. 8hether you aspire to own a yacht or vacation home, to pay for your child+s
education or to simply save up for a new car, you should consider it in your asset allocation plan. %ll of
these goals need to be considered when determining the right mix.
/or example, if you+re planning to own a retirement condo on the beach in 45 years, you need not
worry about shortterm fluctuations in the stock market. -ut if you have a child who will be entering
college in five to six years, you may need to tilt your asset allocation to safer fixedincome
investments.
4+ Time Is Yor 5est /riend
#he 0.:. Department of *abor has said that for every 25 years you delay saving for retirement "or some
other longterm goal6, you will have to save three times as much each month to catch up. !aving time
not only allows you to take advantage of compounding and the time value of money, it also means you
can put more of your portfolio into higher riskAreturn investments, namely stocks. % couple of bad years
in the stock market will likely show up as nothing more than an insignificant blip >5 years from now.
&+ 6st Do It7
1nce you+ve determined the right mix of stocks, bonds and other investments, it+s time to implement it.
#he first step is to find out how your current portfolio breaks down. It+s fairly straightforward to see the
percentage of assets in stocks versus bonds, but don+t forget to categorize what type of stocks you own
"small, mid or large cap6. ,ou should also categorize your bonds according to their maturity "short, mid
or long term6. Mutual funds can be more problematic. /und names don+t always tell the entire story.
,ou have to dig deeper in the prospectus to figure out where fund assets are invested.
The 5ottom Line
#here is no one standardized solution for allocating your assets. Individual investors require individual
solutions. /urthermore, if a longterm horizon is something you don+t have, don+t worry. It+s never too
late to get started. It+s also never too late to give your existing portfolio a facelift. %sset allocation is
not a onetime event, it+s a lifelong process of progression and finetuning.