Diversification is a fundamental investment
concept that most investors have no trouble
understanding. If, for example, an investor
owns equal dollar amounts of only two stocks,
and one suffers a 50% loss, his or her portfolio
has gone down in value by 25%. But if the investor
owns ten stocks, and one drops by 50%, his or
her portfolio has suffered only a 5% loss.
With a diversified stock portfolio, risk may
be reduced because different stocks tend to
rise and fall independently of each other. On
a broader scale, combinations of different investment
assets may help balance out each other’s fluctuations
in price, lowering, though not eliminating,
the overall risk.
Categorizing risk
The ultimate goal in a diversification strategy
is to improve investment performance while managing
risk. One way to categorize risk is to distinguish
between unsystematic risk and systematic risk.
Unsystematic risk is risk that is specific
to a company. Often, this risk involves some
kind of dramatic event such as a strike, a fire
or some natural disaster. A company’s slumping
sales also fall within this category. Diversification
among the stocks of many companies reduces unsystematic
risk because, of course, it’s highly unlikely
that every one of the unhappy events listed
above will occur in all companies.
Conversely, some events can affect all companies
at the same time. This systematic risk includes
such occurrences as inflation, war and fluctuating
interest rates—generally, those events that
influence the entire economy. Of course, diversification
cannot eliminate the likelihood of these events
happening. Systematic risk accounts for most
of the risk in a diversified portfolio.
A diversified stock portfolio: how
much?
One way that academic researchers measure investment
risk is by looking at stock price volatility.
A classic 1968 study by J.L. Evans and S.H.
Archer, “Diversification and the Reduction of
Dispersion,” concluded that an investor who
owned 15 randomly chosen stocks would have a
portfolio no more risky than the market as a
whole. This research confirmed earlier advice,
coming from instinct and experience, that Benjamin
Graham gave to investors in his 1949 book, The
Intelligent Investor. Graham recommended owning
from ten to 30 stocks to achieve proper diversification.
A study published in 2001 (“Have Individual
Stocks Become More Volatile?” by John Campbell,
Martin Lettau, Burton Malkiel and Yexiao Xu)
suggests that those numbers may be too small.
To replicate the risk of the market as a whole,
according to the study, the “excess standard
deviation” of portfolio returns needs to be
brought down to 5%. In the 20 years ending in
1985, an investor could have achieved this goal
by owning 20 stocks. But, in the period from
1986 through 1997, the professors concluded
that one needed to own 50 stocks to reach the
same result!
Choices in diversification
Of course, an investor who invests for income
will diversify his or her holdings among different
bonds. In this case diversification usually
means owing long-, intermediate- and short-term
government bonds. Other categories might include,
when appropriate, municipal, corporate and,
sometimes, high-yield (“junk”) bonds.
It is possible for an entire asset class to
do poorly for an extended period of time (as
we have seen in recent years). Therefore, it’s
a common diversification strategy for investors
to spread their money across asset classes—including,
for example, stocks, bonds, cash instruments,
and real estate—in their portfolios.
Finally, some investors may want to think in
global terms. By investing outside of the U.S.,
investors are addressing the risk of extended
bear markets at home. Global investing includes
additional risks, however, such as currency
fluctuations and political uncertainty.
May we offer our assistance?
Risk always will be a cause for concern. There’s
always a fear of the unknown. Still, knowledge
and experience can help improve the odds that
you’ll achieve success as an investor in the
long term.
We’ll be glad to help you develop a strategy
that meets your specific needs as an investor.
One designed and implemented to take only the
risks with which you are most comfortable. We
look forward to the opportunity to tell you
more.
Bonds are subject to market and interest rate
risk if sold prior to maturity. Bond values
will decline as interest rates rise and are
subject to availability and change in price.
Stock investing involves risk including loss
of principal. There is no guarantee that a diversified
portfolio will enhance overall returns or outperform
a non-diversified portfolio. Diversification
does not ensure against market risk.
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