We all know that risk and return go hand-in-hand. As investors, we are encouraged to think about how much risk we can/want to assume and then build a portfolio that reflects our risk tolerance and objectives. But, investment risk is not a straightforward concept. There are two, broadly different kinds of investment risks: avoidable, concentrated risks and unavoidable market-related risks, but both can be mitigated through diversification.
Avoidable Concentrated Risks
Concentrated risks are the ones that affect a particular stock, bond or sector. Even in a bull market, one company can experience an industrial accident, causing its stock to plummet. A municipality can default on a bond even when the wider economy is thriving. A natural disaster can strike an industry or region while the rest of the world thrives.
In the science of investing, concentrated risks are considered avoidable. Bad luck still happens, but you can dramatically minimize its impact on your investments by diversifying your holdings widely and globally. When you are well diversified, if some of your holdings are affected by a concentrated risk, you are much better positioned to offset the damage done with plenty of other, unaffected holdings. If you try to beat the market by chasing particular stocks or sectors, you are exposing yourself to higher concentrated risks that could have been avoided. As such, you cannot expect to be consistently rewarded with premium returns for taking on concentrated risks.
Unavoidable Market-Related Risks
If concentrated risks are like bolts of lightning, market-related risks are encompassing downpours in which everyone gets wet. They are risks that apply to the market as a whole; they are the ones you face by investing in capital markets in any way, shape, or form. If you put your cash under your mattress, it will be there when you go to get it (it may be worthless due to inflation, but that’s a different risk which we will address later). Very simply, if you invest in the market, you’re exposed to market risk.
Every investor faces market risks that cannot be “diversified away.” Those who stay invested when a market’s risks are on the rise can expect to eventually be compensated with higher returns. But they also face higher odds that results may deviate from expectations, especially in the near-term. That’s why you want to take on as much, but no more market risk than is personally necessary. Diversification becomes a “dial” for setting the right volume of market-risk exposure for your individual goals.
Whether we’re talking about managing concentrated or market-related risks, diversification plays an integral role. A key reason diversification works is related to how various market components respond to price-changing events differently. Instead of trying to move in and out of favored components, the goal is to remain diversified across a wide variety of them. This increases the odds that, when some of your holdings are underperforming, others will outperform or at least hold their own. Quite simply, diversification helps minimize the total risk you must accept as you seek to maximize expected returns.