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Risk Diversification

Updated on January 5, 2024
Article byPrakhar Gajendrakar
Edited byShreya Bansal
Reviewed byDheeraj Vaidya, CFA, FRM

Risk Diversification Definition

Risk Diversification is the investing strategy where an investor participates across different industries and sectors, purchasing or investing in different financial instruments and products to manage, mitigate, prevent, and avert financial loss. All these investments fall under the investor’s portfolio.

Risk Diversification

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It is a widespread technique and used by not only long-time investors but also novice individuals, practically subscribing to the theory of not putting all your eggs in one basket. Portfolio risk diversification not only helps to avert risk but also allows an investor to explore different market options and return-bearing securities. It can also be done based on short or long-term financial goals.

Key Takeaways

  • Risk diversification is the practice of investing in different sectors and industries as a risk management strategy to avert financial loss.
  • There are typically two types of risks: systematic risk and unsystematic risk, which are also referred to as market risk and specific risks.
  • It allows investors to explore different financial markets and instruments not only to create a balanced portfolio but also to have multiple assets.
  • Proper and smart risk diversification can help an investor make a profit even in a bearish or declining market.

Risk Diversification Explained

Risk diversification is the process of investing in multiple asset classes in such a manner that it mitigates market risks and protects the portfolio from any form of financial loss. When an investor invests in a particular asset class, it refers to a portfolio, but typically, a portfolio has multiple investments across various industries and sectors. It can be anything from a mutual fund, a bunch of stocks, real estate, digital gold, or even cryptocurrencies. Still, risk diversification allows an investor to regulate the portfolio or align the investments in such a way that it reduces the risk of loss.

The risks are mainly of two types: systematic and unsystematic risk. The former is when the whole market suffers from it, but the latter is when a particular sector or industry suffers from it, which is also the reason it is referred to as specific risk. Risk diversification’s meaning lies in an investor’s ability, understanding, and wisdom to allocate capital in such a way that a well-balanced portfolio is created that can withstand any potential market risk, uncertainty, and backdrop.

When an investor applies systematic risk diversification techniques, they cultivate their funds and investments and adequately distribute their funds in a variety of financial instruments, products, and asset classes so that if a particular sector suffers a loss, the other investments make up for it. Because if this doesn’t happen, the investor will suffer a considerable loss. The whole concept revolves around risk and return collaboration.

An investor doesn’t need to explore all asset classes; they can very well construct a portfolio in the stock market itself, carefully buying stocks of different industries and sectors and buying multiple stocks from the same sector as well.

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Steps

There are three main steps of risk diversification to follow which are –

  1. Capital allocation: In this step, an investor gauges the overall risk of their portfolio and calculates the risk exposure their investment has. It is an essential step because risk is always measured with respect to the potential return. It helps an investor understand and make a decision whether to hold to an investment with a higher degree of risk depending on its return level. It also is the process of allocating capital to investments that are either risky or have a risk associated with them.
  2. Asset allocation: This step is where an investor decides to allocate funds or make investments in asset classes or securities that belong to different sectors and industries based on the relative risk that is parallel to the expected return of each asset. If done smartly, an investor can reduce their portfolio risk lower than the accumulated risk of all the assets. An investor can do it in different ways and at different times to maintain the lower risk.
  3. Security selection: Every asset class is a series of securities and assets within it. So, in the final step, an investor makes sure that if they are investing in a particular asset class, they are doing it in a diversified manner as part of their capital allocation process. In simple words, if an investor decides to invest in stocks, they are not investing in any particular stock but a group of stocks belonging to different sectors and industries, from small-cap stocks to blue-chip companies.

Examples

Let us understand the concept through the following hypothetical and real-world examples.

Example #1

Suppose John is a wise investor and spends most of his time following market news, reading investing books, watching videos, and scrolling through blogs on finance and everything related to finance. Over the years, he has created a good portfolio for himself, in which he has purposely held stocks of different companies across industries and varying sectors.

Apart from this, he has diversified his investments into real estate, digital gold, cryptocurrencies, and mutual funds. Therefore, even when a systematic risk arises in the market, his portfolio remains well-balanced. John handles the situation very well, mitigating risk and suffering minimum loss. At the same time, if it is a specific risk, John comes across a market news, rumor, or announcement regarding a particular sector. He immediately shifts his stock to a different company. Making this early move, he ensures that his portfolio remains intact.

It is a simple example of how John or any investor can create a well-balanced portfolio to prevent losses and mitigate risks.

Example #2

The Bank of Thailand has huge confidence in gold and believes it to be a haven for asset and risk diversification. The Deputy Governor for its central bank for monetary stability said in an interview with Bloomberg. The deputy governor accepted that gold deposits had protected Thailand’s foreign reserves from market fluctuations and other geopolitical uncertainties in the past.

Given the scenario, to mitigate the investment risks, the central bank has continuously raised its gold reserves in the past three years. They accepted that risk diversification is crucial and gold has become a prominent asset, especially after Hamas launched attacks on Israel, which surged the gold prices by 9%. The central bank’s data shows that Thailand’s gold reserves have doubled since 2019.

Importance

The importance of risk diversification is –

  • It reduces the risk of financial loss in case of a financial crisis, slowdown, market crash, and unsystematic risks.
  • Since an individual invests in multiple industries and sectors across the markets, each has its level of return with time and adds to the earnings of the investor.
  • If not for risk diversification, many investors will never try other markets and financial products and keep on investing in one place, therefore allowing exploration.
  • It can be done anytime, either with a good plan or even days before an investor comes across market news, rumors, or notions or predicts a potential risk in the coming days.
  • It is observed as an essential risk management tool among investors and market experts, especially while creating a portfolio.

Frequently Asked Questions (FAQs)

1. Does risk diversification increase returns?

Risk diversification is mainly observed as a risk management technique, an investing strategy where the investor is not employing it with the objective of earning more but with the ideology of protecting better. However, a wise investor with properly calculated risk and distribution of capital can gain good returns in a declining market as well.

2. What are the benefits of risk diversification?

The benefits of risk diversification are –
– It helps create a balanced portfolio.
– It keeps an investor ready with the idea that market risk can come, and they should be prepared for it.
– If not for diversification, many investors may not even explore other investments and financial markets.

3. Are there any downsides to risk diversification?

One potential downside is that overly diversifying a portfolio may lead to lower potential returns. Additionally, in times of strong market trends, certain concentrated investments might outperform a diversified approach. Striking the right balance is essential.

This article has been a guide to Risk Diversification and its definition. Here, we explain the concept along with its examples, steps, and importance. You may also find some useful articles here –

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