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. Here, we look at why this is true and how to accomplish diversification in your portfolio.
- Diversification reduces risk by investing in investments that span different financial instruments, industries, and other categories.
- Risk can be both undiversifiable or systemic, and diversifiable or unsystematic.
- Investors may find balancing a diversified portfolio complicated and expensive, and it may come with lower rewards because the risk is mitigated.
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Different Types of Risk
Investors confront two main types of risk when investing. The first is undiversifiable, which is also known as systematic or market risk. This type of risk is associated with every company. Common causes include inflation rates, exchange rates, political instability, war, and interest rates. This type of risk is not specific to a particular company or industry, and it cannot be eliminated or reduced through diversification—it is just a risk investor must accept.
The second type of risk is diversifiable. This risk is also known as unsystematic risk and is specific to a company, industry, market, economy, or country. It can be reduced through diversification. The most common sources of unsystematic risk are business risk and financial risk. Thus, the aim is to invest in various assets so they will not all be affected the same way by market events.
Why You Should Diversify
Let’s say you have a portfolio of only airline stocks. If it is announced that airline pilots are going on an indefinite strike and that all flights are canceled, share prices of airline stocks will drop. That means your portfolio will experience a noticeable drop in value.
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