Diversifying Your Portfolio
Portfolio diversification theory traces its roots in a 1952 paper by Pr. Harry Markowitz entitled "Portfolio Selection." In his paper, Markowitz described how to combine assets in a portfolio to mitigate risk, leading him to conclude that a portfolio's overall risk could be reduced while increasing the expected rate of return by holding a variety of inversely correlated assets -- in other words, by holding assets in a mix of classes that are likely to move in opposite directions, no matter what the condition of the overall market. Investors and money managers alike use portfolio diversification to manage their investment risk still today.
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Identify Risks
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Risk is the possibility of something happening contrary to the desired result. Anytime you make an investment, you take on a certain amount of risk. As it pertains to portfolio diversification, risk is the possibility that some of your investments will be worth less than what you paid for them when you sell them. In order to manage your risks, you need to first identify them. The two main categories of risk include systematic and nonsystematic risk.
Systematic Risk
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Systematic risk is a type of risk that affects almost all companies alike. Some examples of systematic risk include: interest-rate risk, which is the uncertainty of changes in interest rates; inflation risk, which is the possibility that increases in the prices of goods and services will reduce your purchasing power; currency risk, which exists because currency exchange rates are not fixed and may affect companies doing business overseas; liquidity risk, which is the possibility that you will be unable to convert your investment into cash when needed; and, sociopolitical risk, which is the possibility that social or governmental instability will affect global financial markets. To protect against systematic risk, you should invest in securities that are negatively correlated; in other words, securities that react differently to the same stimulus or economic condition.
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Nonsystematic Risk
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Contrasted with systematic risk, nonsystematic risk is associated with particular products, companies and/or industries and only affects a narrow class of investments. Two subcategories of nonsystematic risk are management risk, which is the risk that bad management decisions will affect the value of a security; and, credit or default risk, which is the possibility that an issuer of a security will stop making scheduled interest payments or fail to return the principal of the investment when it matures. To protect against nonsystematic risk, you similarly spread your investments across a number of companies.
Measure Risk
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Perhaps the most difficult aspect of portfolio diversification is measuring risk. For stocks, risk is measured in what is called the risk premium and for bonds risk is measured by the default premium. Thirteen-week U.S. Treasury (“T”) Bills are the closest things to a risk free investment; thus you can compare the expected return of a T-Bill to another investment to get an idea of the amount of risk the market has priced in. Generally, you can get a rough idea of default premium in bonds by a company's credit rating; and you can get an idea of how correlated a particular stock is to the overall financial market by its beta, or the deviation of its stock price to the norm. A beta of 1 means a stock moves in unison with the overall markets. A beta greater than one means a stock is more volatile than the overall market, and vice versa.
Manage Risk
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To diversify your portfolio, simply divide the total money you have to invest across a variety of asset classes. Next, divide your investments in a particular class of assets amongst a variety of securities within that class. For example, when investing in equities, you may choose to spread that portion of your portfolio across small and large cap companies within several different industries. It is generally agreed that you should spread your money across at least 10 different stocks to best mitigate your risks. Just remember, a variety of stocks alone does not mitigate risk; the stocks must be inversely correlated. A well-diversified portfolio holds a basket of equities, comprising several different companies in a variety of industries, as well as cash, bonds and commodities.
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