You may have heard that diversification is a good strategy for investing. But what does it mean and why does it matter so much?
In investment terms, diversification is a strategy that involves spreading investments across different assets, sectors, industries, and geographic regions to reduce risk. By putting funds into various assets or types of investments, diversification aims to minimize the impact of market fluctuations on a portfolio's overall performance.
Diversification can even involve opening accounts at multiple banks to minimize the risk of one failing. Think of it as putting your eggs in multiple baskets.
When you're well diversified, it means you've got a mix of assets that aren't all moving in the same direction all the time. So, if a couple of your investments aren't doing so hot, it might not tank your whole portfolio because some other ones could be performing well at the same time.
Many investment risks can be lessened through diversification but often are not eliminated entirely. Here is a list of the different risks that can be mitigated through diversification.
Business Risk
Business risk can take many forms and is generally defined as the risk that an investment will decline due to a feature of the particular company. Business risk plays a large part in stock investing, though if you hold corporate bonds you are also exposed to business risk. Common examples include a class action lawsuit or company mismanagement.
The best way to minimize business risk is by investing in a broad range of businesses. Rather than betting the farm on a single company, holding a diverse group of companies’ stock reduces the risk of a single company underperforming.
Default Risk
Default risk is the risk that a borrower will be unable to pay back the debt instrument you own. When you own fixed income, whether it is a CD, bond, or other type, the issuer of the bond has promised to pay your principal back. However, there is always the risk that the issuer will be unable to pay you back and will default on its obligation.
Diversifying your fixed income can reduce your default risk if you own fixed income from many types of issuers. Bonds are given credit ratings that help you discern the default risk of the company or institution. Make sure you understand the default risk of any fixed income before you invest.
Country Risk
This type of risk can involve geopolitical forces in a certain country or region, economic conditions, or regulatory environments. This risk makes it important to diversify the location of your investments in addition to types of investments.
Many investors have a home country bias, causing them to concentrate the majority of their investments in the country within which they live. It is important to recognize that this concentrates the country risk by reducing diversification.
Interest Rate Risk
Interest rate risk takes a few forms and diversification only partially addresses one type of interest rate risk. This is the risk that interest rates will change and will thus change the value of your current bond holdings.
The interest rate environment usually changes due to changes in the Fed Funds Rate, set by the Federal Reserve. Holding a mix of short-term, intermediate-term, and long-term bonds can help balance a portfolio's sensitivity to interest rate changes.
Diversification can help reduce the impact of the ups and downs of the market on your investments. By spreading your investments across different asset classes, industries, and even countries, you're not relying too heavily on the success or failure of any single investment.
Call us at (858) 755-0909 to discuss the role of diversification in your portfolio.
