Diversification: A strategy to reduce your investment risk
Investing has become more popular than ever, with news outlets, online forums, and maybe even your friends and family discussing the next big stock, sector or industry to invest in. Investing entirely in one thing can be tempting when all you hear about are high returns, but it also means the value of your entire portfolio can drop based on the movement of one stock or sector. Learn more below about how diversifying your investment portfolio can help you manage risks that could impact your returns.
Investing in the stock market always carries two inherent risks that comprise your total risk. The first, called systematic risk, is derived from broad market factors that impact the entire market and are something investors can’t control. These include interest rate changes, inflation increases, war, recessions, and even a pandemic like the world is currently facing.
The second, called unsystematic or residual risk, is the risk inherent to the investment in a particular company, industry or market. This can include a new competitor in a company’s space or changing laws or regulations on an entire industry that impacts all the businesses within it. While investors cannot entirely remove unsystematic risk, they can take steps to reduce it and lower the total risk of their investment portfolio.
How do I diversify my investment portfolio?
Diversification is the act of spreading risk across your investments so that when some investments or sectors in your portfolio are performing poorly, you’ll have others performing well. Investors should look at their entire investment portfolio and evaluate the weighting of their investments across companies, industries, sectors and markets. Are most of your investments located in one country?
You may want to explore investing in global stocks. Are you invested in too many technology companies? Consider broadening out into other sectors like financial services, energy or consumer staples. By creating what’s called a balanced portfolio, you can minimize the substantial losses you might experience if you were heavily invested in any one stock or market. If you’re having difficulty building a balanced portfolio, you may want to work with a registered financial planner or registered financial advisor to create a portfolio right for you.
Why diversify my investments if they are doing well?
It may be difficult to justify diversifying your investments if they are doing well, but remember that no security or market will altogether avoid downturns. Regardless of the investment, company, industry or market you choose to invest in, there are various unsystematic risks.
These include business risk, financial risk, strategic risk and legal and regulatory risk. Each of these can impact your returns. Without diversification of your investments in different markets, industries and companies, your investment returns could feel the full effects of all this risk.
You can’t predict the future, but you can hedge against risk.
Even when you thoroughly research your investments, you still can’t foresee all the risks you may encounter. Diversifying your investment portfolio won’t protect you entirely from losses, however, it can help drive steadier returns in the long run and help you achieve your investment goals.