All investments contain some level of risk. If there were no risk to an investment, there would be no return (or reward). The benefit to you of having a diversified portfolio (or a basket that doesn’t contain all one’s eggs) is that you reduce your overall level of risk or exposure to particular risk factors. Risks are classified as diversifiable (you can mitigate your exposure) and non-diversifiable (such as the vagaries of market risk because they are always there). Among diversifiable risks are risks associated with having too much exposure to:
• One industry such as the auto industry. The recent recession put Detroit’s Big Three in various stages of crisis. GM and Chrysler filed for Chapter 11 bankruptcy protection. Ford, while avoiding bankruptcy, faced competitive disadvantages because they didn’t have the benefit of court-ordered, cost-cutting concessions from labor and suppliers. Investing a substantial portion of a portfolio in the auto industry during the past four years would certainly have taken its toll in lost portfolio value.
• Companies of all the same size. It is desirable to have a balance between growth and risk levels in a portfolio. Investing in all small cap stocks, for example, would weight that portfolio towards higher growth and higher risk. A diversified portfolio would contain assets that reflected a balance between small, mid and large cap investments. Another factor to consider in this regard is that investors’ preferences are somewhat cyclical. Large caps might be “hot” while other categories may currently be out of favor.
• Country-specific risk. Exposure to the economy and fluctuations in the fortunes in certain parts of the world present risk factors that investors should be aware of, especially geo-political risk. Most companies deploy their assets world-wide to reduce their exposure domestically or to one country or region. Investors should also diversify out of domestic risk factors as well as examine opportunities to invest in emerging markets globally.
• Time horizon. A diversified investment portfolio is typically allocated between assets that are intended to be held for differing amounts of time: shorter term vs. long term investments. One strategy to achieve this is to have a selection of growth stocks (usually held for a short term investing period of up to 5 years) as well as value stocks (solid companies who produce consistent returns over time and represent a good value when purchased.)
• Asset class diversification. When an investor diversifies a portfolio, it is advisable to diversify all assets and not just think in terms of stocks. Other investable assets such as bonds, real estate, commodities, even fine art, can be used in a diversification strategy to minimize risk associated with being invested in just one asset class. Within each asset class, it is possible to diversify based on the criteria cited above.
Check with your advisor as to whether your portfolio is diversified enough to provide you with the returns you desire without the risk of being too heavily invested in one area.