Diversification: Part 2

by 19 Oct, 2018

Master Risk with Diversification

Part 2 of 3 

In our previous post on diversification, we used different asset classes to spread risk. But it’s also possible to diversify and spread risk within one asset class, like stocks.

To understand diversification on a deeper level, we need to consider the main sources of risk.

Company-Specific Risk

Rather than betting everything on one stock, invest in several companies. That way, one bad set of company results won’t damage your portfolio’s performance.

For example, if you put all your money in Facebook and it tanks, your portfolio tanks too. If you diversify and buy different tech stocks like Microsoft and Apple, you lower your risk. This is because stocks within the same asset class perform differently depending on the underlying business.

Geographic Risk

Every corner of the world is different. Employment, natural disasters, elections and many other factors affect interest rates, currency fluctuations and general economic performance. This impacts financial markets. And it impacts your portfolio.

Another way to lower risk is to diversify your portfolio across geographies. Instead of buying shares in two US automakers – say, GM and Ford – you might decide to purchase shares in a US automaker and a German one, like Volkswagen, who have a large footprint in Europe. That way, you diversify your exposure.

Of course, to make returns you must take some risk. This might involve investing in emerging markets where growth could be stronger but risk may be higher than developed markets. Great investors find the right balance between risk and reward.

Cyclical Risk

Different sectors have different relationships with the economic cycle. Some sectors are defensive, whilst some are cyclical.

Defensive sectors, like healthcare and utilities, tend to ride out tough economic times better than other sectors. This is because consumer demand for staples like water, electricity and groceries tends to remain stable regardless of how the wider economy is performing.

Cyclical sectors like financial services, automakers and real estate tend to suffer. This is because they offer products and services that consumers tend to buy when the economy is performing well and they have disposable income. Consumers only buy cars every few years, so they are less likely to buy when the economy is underperforming.

During the 2008 financial crisis, bank stocks nosedived. When the next crisis rears its head, you’ll be better off holding a defensive stock like healthcare giant Pfizer than a cyclical banking stock like Wells Fargo.

Combining both defensive and cyclical sectors lowers risk and can help drive consistent returns, protecting you from the ups and downs of the business cycle.

Term Risk

Stocks pay dividends at different times. For example, young technology companies like Amazon grow quickly but hold off paying dividends until they’re fully grown. Older firms like Cisco and Oracle pay more consistent dividends, but might not grow as fast.

To build a diversified portfolio that generates stable returns, include young and old companies.

Take Out 

Diversification can be as simple – or as complex – as you want it to be. Great investors go beyond diversification across asset classes to diversify their holdings within asset classes. They strike a balance of companies, sectors, geographies and styles that minimize portfolio risk.

Stay tuned for the final post in our diversification series, in which we’ll be exploring some of the challenges that come with diversification and how to overcome them.

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