In last month's blog post, "The Full-Meal Deal of Diversification," we described how effective diversification means more than just holding a large number of accounts or securities. It means having efficient, low-cost exposure to a variety of capital markets around the globe. Today, we'll expand on the benefits of diversification, beginning with its ability to help you better manage investment risks.
Most of us learn about risk even before we have the words to describe it. Our lessons start when we, say, tumble into the coffee table, or reach for that pretty cat's tail. Investment risks, alas, are a little more complex. They come in two broadly different varieties: avoidable, concentrated risks and unavoidable market risks.
First let's look at concentrated risks. They are the ones that wreak havoc on particular stocks, bonds or sectors. Even in a bull market, one company can experience an industrial accident (Exxon Valdez), causing its stock to plummet. A municipality can default on a bond (Detroit, LA) even when the wider economy is thriving. A natural disaster (Japan's Tsunami) can strike an industry or region while the rest of the world thrives.
In the science of investing, concentrated risks are considered avoidable. Bad luck still happens, but you can dramatically minimize its impact on your investments by diversifying your holdings widely and globally, as we described in our last post. In a well-diversified portfolio, some of your holdings may indeed be affected by a concentrated risk. But it's likely that you'll have plenty of unaffected holdings.
Now on to unavoidable market risks. If concentrated risks are like bolts of lightning, market risks are downpours in which everyone gets wet. They are the persistent risks that apply to large swaths of the market. At their highest level, market risks are those you face by investing in capital markets in any way, shape or form. If you stuff your cash in a safety deposit box, it will still be there the next time you visit it. Invest in the market and, presto, you're exposed to market risk.
Harkening back to our blog about "Jelly Beans and Conventional Wisdom," the market is wise. As a whole, it knows the differences between avoidable and unavoidable investment risks. And heeding this wisdom guides us in how to manage our own investing with a sensible, evidence-based approach.
Managing concentrated risks: When you try to beat the market by chasing particular stocks or sectors, you exposing yourself to higher concentrated risks. And you cannot expect to be consistently rewarded with premium returns for taking on concentrated risks. Balanced diversification allows you to minimize concentrated risks.
Managing market risks: Every investor faces market risks that cannot be "diversified away." Those who stay invested when market risks are on the rise can expect to eventually be compensated for their steely resolve with higher returns. But they also face higher odds that results may deviate from expectations, especially in the near term. That's why you want to take on as much, but no more market risk than you can personally tolerate. Diversification serves as a "dial" for setting the appropriate level of market-risk exposure for your individual goals.
Whether we're talking about concentrated or market risks, diversification plays a key role. Diversification is vital for avoiding concentrated risks. In managing market risks, it helps you adjust your desired risk exposure to reflect your own goals and comfort level. It also helps minimize the total risk you must accept as you seek to maximize expected returns.
In next month's blog, we'll address another powerful benefit of diversification: smoothing the ride on your investing journey.