What is Risk Diversification?

July 30, 20213 min read
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Risk diversification involves combining a variety of different investment types and investments in a variety of industries in a portfolio to help reduce your overall exposure to risk, and the portfolio’s volatility. The idea is that a portfolio diversified across multiple asset types should achieve higher long-term returns with less downside risk than holding a single asset class like stocks or bonds, even if across an ETF or seemingly diversified within the asset class. 

Why is risk diversification important?

The basic idea behind risk diversification in investing is that when one asset class or sector is declining in value, others are rising. The increases in values for the sectors or asset classes that are rising will hopefully be more than the declines in values for those that are falling. By diversifying, you limit the amount of exposure to any singular risk in your portfolio.

Most investors wants to avoid putting all of their eggs in one basket – and in this case the basket is the stock market, where many investors are content to park their money and bear the risk of stock market volatility and downturns. While it’s impossible to invest without risk altogether, most investors look to take on different types of risk and reduce their overall risk exposure by diversifying their portfolio among holdings in multiple asset classes and sectors. For example, stocks tend to rise when bonds are falling and vice versa, so most investors hold both stocks and bonds in their portfolios. Other ways to diversify risk include investing in companies of different sizes, spread across different sectors, and in a variety of geographic regions.

One notable way to diversify a portfolio is with exposure to assets that aren’t correlated with each other. If all the holdings in your portfolio rise and fall with the same types of macro events, like a stock market decline, then your portfolio isn’t truly diversified.

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Reducing risk exposure by tweaking risk-reward profiles

When allocating your portfolio to different asset classes and sectors, it’s important to consider the potential reward against the risk of potentially lower returns. This ratio is the risk-reward profile, and adjusting your portfolio often changes its risk-reward profile.

Before investing in anything, you may have to figure out how much risk you are willing to take in your portfolio. Some risks include losing the principal you invested, returns not keeping pace with inflation, coming up short in retirement if the investment collapses, or paying fees or other costs on investments, like rollover fees. 

You may also want to adjust your portfolio to change the risk-reward profile as you age. A general investing rule of thumb is to invest a higher percentage of your portfolio in bonds and other less volatile investments as you approach retirement age. However, when you are younger, you may be able to afford riskier investments because you have more time to make up for any potential losses that may occur.

Risk diversification is an important part of investing, and few investors can afford not to do it. Investors should decide how much risk they are comfortable taking based on their age, when they need the money and how alternative investments may help reduce certain risks associated with investing.