Investing involves two basic elements: return and risk. Investors often focus on return because it’s pleasant, but spend relatively little time considering risk– the potential downside. Risk is most often measured by standard deviation, which is a measure of the variability of returns. An investment with a large amount of variability of returns (a high standard deviation) has the potential to reap large gains or result in large loses.
Total risk consists of two components: systematic risk and unsystematic risk. Systematic risk, also called non-diversifiable risk, is composed of risks that reflect broad economic activity, are market related, and affect all similar types of investments. These risks can’t be eliminated by adding additional securities to a portfolio.
Unsystematic risk, also called diversifiable risk, is composed of risks specific to an individual investment. Factors such as a company’s management, financial structure, earning power, industry, and marketing strengths are some of the specific aspects that can impact the risk of an investment.
Systematic risk is inherent in all investing. Unsystematic risk can be virtually eliminated through diversification. Over time, a portfolio of two unrelated assets can be expected to be less risky than holding each asset individually because the unexpected above-average performance of one asset offsets the disappointing below-average performance of the other asset. Consequently, the variability unique to each individual asset has a greatly reduced impact on the variability of the portfolio as a whole. Thus, having a diversified portfolio of many individual unrelated assets greatly reduces risk while maintaining a consistently high rate of return.
The performance of unique asset classes tends to be relatively uncorrelated. For instance, stocks and bonds do not usually perform in tandem. The same relationship exists between large and small cap stocks, and U.S. and international stocks. To achieve maximum diversification, an investor should own a portfolio consisting of large, mid, small, and international stocks, and own both growth and value style investments. Corporate, government, and international bonds should also be included. Lastly, real estate and commodities can be used to round out the portfolio.
Diversification is a key element of sound financial planning. A portfolio that is well diversified will sustain its value during market declines much better than one that is not. Speak to a financial advisor to ensure your investments are well diversified, which will reduce risk and maximize return in your portfolio.