Managing Risk by Diversification
Risk is a fundamental part of investing. While risk cannot be eliminated, it can be managed. For most investors, the principal concern is to reduce their risks without penalizing their potential returns. Over the longer term, one of the best ways to lower a portfolio’s risk of share price declines while still earning attractive returns is to diversify.
The single most important investment rule is diversification or spreading your assets across a variety of different types of investments. The value of diversification is often underscored by events in the financial markets, such as sharp drops in stock prices. When you include a variety of investments in your portfolio, its overall performance should be less volatile (and you should have less risk) than if you put all your money in one type of investment.
Diversification offers this benefit because each kind of investment follows a cycle all its own. Each one responds differently to changes in the economy or the investment marketplace. If you own a variety of assets, a decline in one can be balanced by others that are stable or going up.
For instance, foreign stock and bond markets do not always track the U.S. markets’ direction. In U.S. dollar terms, some may outperform the U.S. over certain periods. Therefore, owning a mix of both domestic and international stocks and bonds could reduce the overall volatility of a portfolio because some holdings may rise in value while others are declining. Nevertheless, diversification cannot assure a profit or protect against loss in a declining market.