How to use Diversification to reduce 3 types of risks
April 5, 2011 Leave a comment
The core objective of diversification is to reduce risk – the idea being that peaks and troughs in a specific investment does not affect overall portfolio return objectives.
If one defines risk less as volatility, and more as a either a complete or partial, but permanent loss of capital, then an individual investor would be well-advised to consider diversification to reduce risk of a few primary types:
1. Asset Market or Systematic Risk: What if I am invested in the wrong asset class or market? This is best reduced by a prudent asset allocation decision. Investors should identify different types of asset classes that they want to be invested in along with ideal target percentages in each asset class. This will minimize the impact of being invested in the wrong asset class.
2. Unsystematic Risk: What if I choose the wrong stock or bond or property? This is best reduced by investing in a pool of candidates within the same asset class. So if it is equities, it is best to be invested in a bucket of unrelated good businesses, or in commodities or real estate, again try and be invested in unrelated asset candidates. This will minimize the impact of being invested in the wrong securities.
3. Timing risk: What if I invest at the wrong time? Well – you may have a well-diversified pool of securities in a well adjusted portfolio of asset types, but what if you invest at the peak of the markets? This is best reduced by making periodic investments in the assets of your choice, so that timing risk is reduced. This will minimize the impact of being invested in any asset at purely the wrong time.
For individual investors, more than chasing returns, if prudence is exercised in constructing a portfolio with the objective of reducing risk of the above three types, there are good chances that the returns will take care of themselves.