- When researching and considering stock portfolios, it is important to gain an understanding of risk and how it fits into diversification. A single stock has more risk of not creating a positive return than a stock portfolio. Some investors think long-term with investments, willing to wait out any volatility in price. Other investors are risk-averse, and they will choose a less risky investment over a stock with more volatility. In a market dominated by risk-averse investors, riskier securities must have higher expected returns.
- A stock held as part of a portfolio is less risky than the same stock held by an investor in isolation. The portfolio creates low risk. Banks, pension funds, mutual funds and insurance companies are required by the federal government to keep diversified portfolios. By investing in different markets, holding multiple securities with multiple maturity dates, finding negatively correlated stocks and holding multiple stocks in a portfolio, investors can have a better chance of positive returns on the portfolio with the offset stock activity.
- When creating a stock portfolio, it is important to note that there is a difference between diversifiable risk and market risk. Diversifiable risk may be caused by random events that are particular to an individual firm. Since these events are random, the influence of events, such as a lawsuit or strike can be almost eliminated via diversification. However, diversification cannot entirely eliminate market risk. Market risk affects most firms. Examples of market risk include war, recessions and high interest rates.
- The benchmark for a well-diversified portfolio would be a portfolio of all stocks in the market. Relevant market risk of the stocks within the portfolio is calculated using a beta coefficient. Accordingly, a stock with a high beta will bring a lot of risk to the portfolio. As you calculate the beta for various stocks, you may begin to see groupings of low, average and high beta risk. Calculate the weighted average of these groupings, and you will discover the market risk for the entire portfolio. A "low" beta is generally 1.0 or below.
- The portfolio is diversified with negatively correlated stocks, global markets, low beta coefficients and multiple securities, creating a low-risk stock portfolio. However, low-risk stock does not mean no-risk stock. No matter how diversified the portfolio, there is still a chance that the market will take a turn for the worse and stock values may drop. Even treasury bills provided by the federal government are only near risk-free, not without risk as one may expect from such an investment source.
