Risk Management: Diversification
The best way to reduce your portfolio risk.
Today we delve into the vital topic of risk management and the power of portfolio diversification. We will show you why diversification is the easiest and most effective way to reduce your portfolio risk.
What is portfolio risk?
How to reduce this risk?
What is portfolio risk?
Portfolio risk refers to the potential for losses or fluctuations in the value of your investment portfolio. It is important first to understand what actually makes up portfolio risk.
Total Risk = Systematic Risk + Unsystematic Risk.
Systematic risk (also called Market Risk) arises from factors affecting the overall market. Examples of this could be geopolitical or economic events which affect the entire market, independent of which company or industry you hold.
Unsystematic Risk (also called Company Specific Risk) arises from factors that are unique to a particular company or industry. Examples of this are poor earnings, accounting frauds, or failed product launches.
We can actually completely eliminate Unsystematic Risk (company specific) from our portfolio! We can however NOT eliminate Systematic Risk (market risk). Note that by decreasing the Unsystematic Risk in our portfolio, we are effectively also decreasing our Total Risk!
How to reduce portfolio risk?
The easiest and most effective way to reduce Unsystematic Risk is through diversification. We diversify by holding different assets with a low correlation between them.
A typical example of this would be oil companies and airlines. These two industries have a negative correlation. If the price of oil suddenly shoots up: airline stocks will sharply drop (increase in fuel prices). The stock price of oil companies on the other hand will evidently rise. Any loss in your portfolio caused by your airline holdings, will therefore by largely offset by the increase in value of your oil and energy holdings.
Had your portfolio held airlines and car producers on the other hand (high positive correlation), your entire portfolio would have dropped as a result of the increase in oil prices.
Correlation measures the degree to which two or more assets move in relation to each other. Correlation can range between -1 and 1, where -1 indicates a perfect negative correlation (assets move in opposite directions), 0 represents no correlation (assets move independently), and 1 signifies a perfect positive correlation (assets move in tandem). The lower the correlation between your assets, the better!
Below we include a table with the correlation between the 11 different industry sectors in which all companies can be categorized. Remember that the lower the correlation, the better!
Are you overinvested in any specific industry? Try to find good investments in companies or industries that have an as low as possible correlation with your current holdings as possible.
In another post we will share a list with all Dividend Aristocrats categorized per industry sector. We hope this tool will help you properly diversify your stock portfolio!
As always, we encourage you to consult with a qualified financial advisor who can provide personalized guidance based on your specific circumstances and investment goals.
Wishing you successful risk management and a resilient portfolio!