With the unfortunate decision by Russia to invade Ukraine likely to dominate our news cycles for the next few weeks, it’s important to take some time this week to talk about the single most important factor in lowering your investment risk: diversification. Having a good balance of investments provides benefits in all markets, whether it is rising, falling, or reacting to outside factors such as geopolitical conflict and war. I want to cover the different types of risk your investment portfolio faces in all markets, what diversification does to those types of risk, and how investment professionals use this knowledge to build portfolios that benefit investors. We can break investment risk into two key types.
This risk is easy to explain without confusing everyone with advanced statistics. Systematic risk is the risk that exists in all investments at the market level. No matter how much we attempt to diversify our portfolios, there will always be a minimum level of risk in investing in capital markets. This is most easily observed in equities when we see all of the sectors of the market go up (or down) over a period of time. Some of these sectors may move more than the other, but they all go up together.
This is the risk that exists in a specific security, whether we talk about a company’s stock or a bond. As we can all see, stock prices and bonds go up and down differently depending on a variety of factors. It could be a good or bad earnings report, an announcement of a lawsuit, discovering a new product, or lots of other company-specific news. Each of these events affect the specific stock without affecting the market equally. These events make them go up or down more than the general market might be on a specific day. Diversification allows us to be able to hold the stock and remove the harmful effects of large movements in the specific price on the whole investment portfolio.
How I Use Diversification to Manage a Portfolio of Assets
There are always things going on in the world both at home and abroad that can be used to form opinions on market direction. As an investment manager, I’m looking for things in the market that I think will make money in the long term. That could mean investing in large blue chip stocks, buying commodities as a hedge on inflation, or buying bonds that I believe will outperform. Being diversified helps me to balance the risk out. An example of this is going on right now. If I have a fictional portfolio invested in stocks and bonds that I am managing, I am investing in two asset classes that tend to not move together very much. There are times that stocks and bonds move together and others when they go different directions. I use other assets to further diversify and protect against risks. If I feel like inflation is a problem, I can buy small positions in inflation-protected bonds or commodities like gold. If I think we are headed toward a potential recession, I can increase my investments in bonds and cash and reduce my investment size in the stock market.
Constructing portfolios for clients boils down to a simple process for me. I need to have a strong understanding of what my client wants to achieve with the money. I must ask the right questions to get a sense of their risk tolerance. Once I know these things, I can build a base portfolio with assets that are suitable for them, using different asset classes to achieve the diversification I’m looking for. I’m constantly looking for ways to add value to my client’s investments. One of the ways I can do that is by understanding how markets react to new information, observing new data in the markets, and forming an opinion on what that might mean for the overall economic picture. I incorporate that into my client’s investments by taking positions that will take advantage of those opinions.
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