Investors are generally aware that it is important to have a diversified portfolio. Unfortunately, many people do not structure their investments in an optimal manner.
When investing, there is a trade off between risk and return. Essentially, someone wants to maximize their expected return for a given level of risk taken.
People generally realize that investing in the stock market entails risk. However, how one goes about structuring their investments can help to mitigate one’s risk.
If someone has a choice of investing in their company stock, or a diversified fund, the company stock will have more risk. There are essentially two risks when investing with individual stocks, market risk plus the risk of the specific companies.
No matter how well a stock portfolio may be diversified there is market risk. if the stock market has a down year, a well diversified portfolio will drop in line with the market averages.
For a portfolio that is not well diversified, someone still has market risk, but in addition there is company risk. For example when the stock market drops most individual stocks will decline, but there is the risk that a particular company can drop more than the market.
The well-diversified portfolio essentially eliminates company specific risk. That is because some stocks in the portfolio are doing better than the market, while others are doing worse. Essentially the bad stocks are being cancelled out by the good stocks.
For those who invest with individual stocks there is more to diversification than the actual number of stocks in a portfolio. For example some portfolios can be better diversified with 15 stocks versus those that may have 50.
What is most important in having a diversified portfolio is having representation across industries. An investor would need to know the market weightings of key industry groups, such as Technology, Health Care, and Financials and structure one’s portfolio to be somewhat in accordance with those weightings.
In addition the market averages are dominated by large companies. Someone could have a diversified portfolio by industry groups, but if the stocks are primarily smaller companies, the performance will differ significantly from the market averages.
Because of the difficulty of structuring a well diversified portfolio with individual issues most investors are better off purchasing funds that are already diversified. As with individual stocks, it is not necessarily the number of funds that are present in one’s portfolio that determine risk, but that the funds in combination work to maximize return for a given level of risk.
Having multiple funds of the same category, such as small cap, does little to reduce risk. What is most important is to have a well diversified large cap fund, such as an S&P 500 index, and supplement that fund with additional funds, such as small and mid-cap, international and emerging markets, subject to one’s risk level.
The previous discussion focused on structuring one’s stock portfolio. However, most investors, other than those who have a high risk tolerance, will want some investments other than stocks to provide additional diversification.
Bonds provide significant diversification benefits relative to stocks. Unfortunately, in the current interest rate environment bond yields are near record lows, which does limit their relative attractiveness. Nonetheless, having some investments in bonds and/or money market accounts is still appropriate for reducing risk.
There is no way to completely reduce risk. Even “safe investments” like money market accounts have risk that one is not keeping up with inflation. However, a well structured portfolio can help to minimize risk, while still maintaining the potential for appreciation.