What Is Diversification?
There is a risk involved in any investment you make, diversification is a strategy to minimize the risk of your investment portfolio.
Why Diversification Is Important
The actual return of an investment might be better or worse than you expect. If you diversify your investment in a well-balanced portfolio, you can minimize your risk. Because investments that perform well and those perform badly will cancel each other out. However, remember that you can’t minimize the risk of your investment to zero unless you are investing in a risk-free investment such as government bonds.
What Are the Types of Risks
There are two types of risks involved in any investment. They are systematic risk and unsystematic risk.
Systematic risk is inherent to the entire market. You can’t minimize systematic risk by diversification, few examples of systematic risk are, wars, inflation, interest rate, recessions, and pandemics. Coronavirus is a recent example of systematic risk. Because it affects the entire market irrespective of the industry. You have to accept the systematic risk if you invest in an investment other than risk-free investments. Investors expect an extra return for accepting that additional risk, for example, 10 years maturity United States Government Bond which is a risk-free investment, has a yield below 1%. But if you are ready to accept the risk in the stock market and invest, you can earn around 9% in S & P 500.
This is the risk which you can diversify away. Unsystematic risk is inherent only to a specific company or a specific industry. It does not affect the entire market. Let’s say you invest massively in the health care stocks, you are at risk if some event happens that affects the health care industry. For example, if the health care industry employees decided to go on strike, it will affect the stock prices adversely.
How to Diversify Unsystematic Risk
This is one of the most common diversification methods. You can invest in different asset classes such as equities, bonds, cash and cash equivalents, real estate, and commodities to diversify the unsystematic risk, for example when interest rates rise, often equity prices fall and bond prices rise. Because investors move their money to bonds to earn a higher return with lower risk. So, if your portfolio includes stocks and bonds, they would perform differently than your portfolio includes only equity stocks at the time of an equity stocks drop.
Invest in Different Industries
Another way of diversifying your investment is to invest in different industries. You can invest in industries such as airlines, banking, insurance, IT, infrastructure, automobile, energy, and so on.
You should remember that even you have a well-diversified portfolio, still you are exposed to systematic risk. Because it not possible to diversify systematic risk away.