Diversifying Investments to Minimize Risks
Posted February 19, 2016 in Articles
While all investments are subject to risk, diversification is a technique that can be used to minimize your exposure to risk. Investment diversification involves spreading your money among a number of different kinds of investments in order to reduce risk. This investment strategy correlates to the age-old adage: “Don’t put all your eggs in one basket.” In essence, by placing your money in multiple investments you are expecting that when some of your investments are not doing well other investments in your portfolio will perform positively, offsetting the negative performance.
Systematic Risks v. Unsystematic Risks
Investment risks are generally broken down into two types of risks:
1. Systematic Risks. Also known as market risks, systematic risks are risks associated with broad market factors and dynamics. Systematic risks affect the entire market and include macroeconomic conditions such as inflation, recession, war, and adjustments in interest rates.
2. Unsystematic Risks. Unlike systematic risks, unsystematic risks are risks that are specific to a particular company, industry or geographic location. For instance, company mismanagement, labor strike, product recall, or natural disaster, such as a hurricane or flood, are all examples of unsystematic risks. Exposure to unsystematic risks can be minimized through proper portfolio diversification.
Diversifying an Investment Portfolio
While systematic or market risk is impossible to eliminate, investors can work to mitigate these risks by adopting sound asset allocation strategies. Asset allocation involves spreading your investments across different asset categories such as bonds, stocks, cash, and alternative investments. By investing in a mix of asset classes you may be able to lower your investment portfolio’s sensitivity to market swings. The key to achieving effective asset allocation is to place your investments in asset categories that move in different directions under different market conditions.
Unlike systematic risk, unsystematic risk can be greatly reduced by diversifying your investments across different companies and industries. For instance, rather than investing solely in the technology industry, an investor may develop an investment portfolio that includes technology but also represents different industry sectors such as manufacturing, utilities, financial services and healthcare. Investors can also further diversify their investment portfolios by investing in companies located in different geographic markets.
Diversifying your portfolio is not a one-time event - when done properly, diversification is an ongoing process. In order to maintain the benefits of diversification you will need to monitor and rebalance your investment portfolio on a regular basis or when you experience a change in your financial situation. If you do not rebalance your portfolio you are likely to face greater risks over time and your asset allocation may no longer match your investment goals and tolerance for risk.
While diversifying your investment portfolio can be a challenging process, a proper diversification strategy will go a long way in helping to minimize your investment risk. If you have questions about your investment portfolio and asset allocation techniques, the global network of consultants at Mithras Investments, LLC can work with you to develop an effective diversification plan. Contact us today.