Every day we expose ourselves to a certain amount of risk. For example, driving down the interstate can be a risky endeavor. However, that is a risk we accept because we know that we need to get to our jobs to earn income. There are things that we do to mitigate the risk on the road like wear seatbelts, drive at a reasonable speed, and stay up-to-date on vehicle maintenance. But not all risks of driving go away. Similarly, investing has inherent risks and there are things that we can do to help mitigate the risks.
Diversification can mitigate some but not all investment risks; there will always be some level of risk in an investment. Investment risk can be categorized in two ways: 1) diversifiable risk and 2) nondiversifiable risk. In other words, there is an element of risk management that you can help control and an element that is out of your control.
What are diversifiable risks? These are risks that can be mitigated by adding additional investments to a portfolio. There is an old analogy of “having all your eggs in one basket”. Instead of owning one stock or a basket of similar stocks, diversification encourages to own securities of different sizes, structures (e.g. stocks and bonds), industries, etc. Diversification preaches to “have your eggs in several baskets”. A few common examples of diversifiable risks are the following:
- Business risk - the ability/inability for the business to generate future earnings and pay investors dividends.
- Financial risk - the uncertainty of an organization to pay its financial debts.
- Political risks - a country’s political climate can cause adverse effects on an investment.
What are “nondiversifiable risks”? These are systematic risks. Simply adding additional stocks or bonds to a portfolio doesn’t protect you from these risks since they affect the market and the economy as a whole. These risks are influenced by interest rates, inflation, currency values relative to one another, and investor behavior on a macro level.
Is there a “risk-free” investment? No. If a return is expected, there will be risk involved in an investment. If more risk is taken, more reward (return) is expected. Otherwise, why would the risk be taken in the first place? Some might point out that United States Treasuries are considered “risk-free”. Although U.S. debt is widely considered to be one of the safest investments out there, it isn’t free from risk as this article nicely outlines.
There are additional risks that should be considered that affect stocks, bonds, and other assets differently. Each investor has a different appetite for the amount of risk that he or she is willing to take and they should recognize that with a different level of risk comes a different expectation of return.
Although not perfect, we have learned diversification strategies throughout the history of capital markets that can help investors achieve their goals.
Are you mitigating your risks to a level that you are comfortable with? One place to start is to better understand the financial risk that you are willing to take. We use a software called Riskalyze to understand the risk level of our clients. Once a comfortable risk level is determined, you should take a look to see if your portfolio reflects the appropriate amount of risk. Back to the driving analogy: people accept the risk of driving because they get rewarded by the opportunity to have a job and earn income.
With investing, people accept a reasonable amount of risk because they believe that by doing so they will be able to reach their financial goals and dreams.
Feel free to comment on this topic and please reach out if you would like to discuss in further detail. Thanks for reading!