For starters, allow me to provide a quick definition:
Diversification - (1) the process of making diverse; giving variety to (2): to divide funds with the expectation that the positive performance of some will offset negative performance of others (as in investing).
Diversification can be compared to a kitchen sink casserole; it takes time, requires a handful of ingredients and if not executed well, it can result in an experience that is hard to stomach. Just as I believe in making use of food that may spoil, I also believe in diversification. However, there are a few issues that investors should consider when developing a diversification strategy.
Most investors have been told to diversify their portfolio. They think if they buy companies that are in different industries that they will be covered if there is some adversity in the markets. The problem is that they do not fully understand the risks in the markets and how to offset those risks. To trade properly, you need to understand the degree of risk you are taking on by involving yourself in the markets.
There are several risks that any trader or investor will face. Depending on the type of investment or trading vehicle you select, you will be exposed to one or many of these types of risk. The levels of risk are listed in order along with the securities that are involved at those levels.
Systemic Risk – These are shocks to the entire financial system where there are few to no safe havens left. Everyone experienced this during the 2008 collapse in the global markets.
Asset Class Risk – Stocks, bonds, commodities, and currency markets all go through cycles where they are bullish or bearish. You face the risk of entering at the wrong part of the cycle for any of these asset classes.
Country Specific Risk – Countries grow at different paces and can offer distinct opportunities and risks based on economic projections, political stability, and other factors.
Sector Risk – Companies fall into sectors: consumer discretionary, technology, basic materials, industrials, energy, consumer staples, services, utilities, and financials. The sectors also undergo bullish and bearish cycles, falling in and out of favor with investors.
Industry Risk – Within these sectors, there are many industry labels that inform investors about the nature of a company's products or services. Companies also fall into cycles.
Company Risk – Individual stocks have risks tied to the company's operations. Lackluster earnings, accounting irregularities, and corporate member changes are all issues you face.
If you trade or invest in individual stocks, you are exposed to the highest levels of risk. Even if you try to reduce risk by buying many stocks in different industries or sectors, you still have the asset class and company risk. When it comes to minimising your risk, you want to balance risk and reward. When you increase your risk, you also increase your potential for profit. You will usually see larger price movements with stocks than you will see with exchange traded funds, or ETFs, but most ETFs hold up much better than individual stocks if a company encounters an issue.
There are several risks that any trader or investor will face. Depending on the type of investment or trading vehicle you select, you will be exposed to one or many of these types of risk. The levels of risk are listed in order along with the securities that are involved at those levels.
Systemic Risk – These are shocks to the entire financial system where there are few to no safe havens left. Everyone experienced this during the 2008 collapse in the global markets.
Asset Class Risk – Stocks, bonds, commodities, and currency markets all go through cycles where they are bullish or bearish. You face the risk of entering at the wrong part of the cycle for any of these asset classes.
Country Specific Risk – Countries grow at different paces and can offer distinct opportunities and risks based on economic projections, political stability, and other factors.
Sector Risk – Companies fall into sectors: consumer discretionary, technology, basic materials, industrials, energy, consumer staples, services, utilities, and financials. The sectors also undergo bullish and bearish cycles, falling in and out of favor with investors.
Industry Risk – Within these sectors, there are many industry labels that inform investors about the nature of a company's products or services. Companies also fall into cycles.
Company Risk – Individual stocks have risks tied to the company's operations. Lackluster earnings, accounting irregularities, and corporate member changes are all issues you face.
If you trade or invest in individual stocks, you are exposed to the highest levels of risk. Even if you try to reduce risk by buying many stocks in different industries or sectors, you still have the asset class and company risk. When it comes to minimising your risk, you want to balance risk and reward. When you increase your risk, you also increase your potential for profit. You will usually see larger price movements with stocks than you will see with exchange traded funds, or ETFs, but most ETFs hold up much better than individual stocks if a company encounters an issue.
To really be diversified, you should invest or trade in multiple asset classes, such as futures or forex, to spread your exposure out over different asset classes. Even if you own a tech stock and a financial company, you will lose when the stock market collapses. Know your risks and manage them when trading. Success comes from protecting your capital as much as it comes from making winning trades.
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