Let’s first understand the two major risk categories, systematic and unsystematic risks. Systematic risk is the type of risk that underlies an entire system, be it the stock market, the real estate market or even the global economy. Unsystematic risk, also referred to as specific or idiosyncratic risk, is specific to a particular asset like a stock or property, or a similar group of assets such as technology or airline stocks.
The factors that contribute to each type of risk are different. For systematic risk, aspects like interest rate changes and recessions can cause entire markets to move. For unsystematic risk, the factors are more localised, like business failure of a specific company or industry (e.g. an airline crash affecting airline stocks or increased privacy regulations affecting technology stocks).
While all investments are exposed to both types of risks on some level, diversification can help manage them to some extent.
The idea behind diversification is simple: by diversifying your investment portfolio, you are spreading your risks around. Hence, a dip in a single security or asset class will not have as large a negative effect.
The key to this is correlation — offsetting the risk of one type of asset against another. Correlation is the degree by which two securities move in tandem. For example, an index fund that tracks the Straits Time Index will be perfectly correlated with the index. On the other hand, gold prices and bonds are lowly or even negatively correlated with stocks, meaning their prices don’t move in tandem, and sometimes may even move in opposite directions.
A well-diversified portfolio thus consists of groups of assets which are lowly or negatively correlated with each other. An investor holding a portfolio of 30 different technology stocks is not diversified at all. But an investor with a 30-stock portfolio covering a range of industries, bonds and real estate, has a decent level of diversification.
Diversification can help manage the unsystematic risk component of your portfolio and, to a certain extent, the systematic risk as well; but you will always be exposed to the systematic risk of the larger global market.
The two main ways to diversify your portfolio are:
- Within an asset class: An investor may only own stocks but these could be diversified across a wide range of industries. Thus, the unsystematic risk of each individual stock is largely mitigated.
- Among asset classes: This is a more diversified portfolio, as mentioned in the above example where the investor holds a mix of stocks, bonds and real estate.
While correlation is the key idea behind a well-diversified portfolio and hedge funds may calculate specific correlation coefficients between their various assets to create an ideal portfolio, this is beyond the scope of an individual investor.
Instead, use diversification as a broad guideline to get a general idea of how certain asset classes are correlated. As long as you diversify your portfolio across a broad range of industries and asset classes, you can reap most of diversification’s benefits.
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This article is brought to you by Standard Chartered Bank (Singapore) Limited. All information provided is for informational purposes only.