What type of risk does diversification reduce

Navneet Dubey. Related stories. Six debt funds that beat bank fixed deposits and made retirees happy over the last 15 years. Tags: investing Planning. Must Listen. Get Daily News on your Browser Enable. Trending news. Indian-American hired woman to slap him every time he used Facebook. In an uncertain environment, volatile market and shortened economic cycles, it is essential to have your portfolio invested across different asset classes. Most importantly, it is recommended to take professional help in creating a portfolio.

The investment professional can guide on how to systematically diversify the portfolio and look at long-term returns and mitigating the risks — both in the short-term and the long-term.

The professional help can guide you to determine what level of risk is acceptable to you, and tailor your portfolio to meet that tolerance. Ultimately, what matters is whether you want liquidity, or if you are willing to wait it out in the long term. This will affect how your investments should be structured. Also, the risk tolerance, the investment goals and financial means of every investor is different. That plays a huge role in dictating the investments mix.

Lastly, evidence-based strategies using logic and knowledge rather than emotion usually do well. As mentioned earlier, diversification does not work the same way with every asset class across every industry in every market. Still, it is an important tool to improve risk-adjusted returns over the long haul. Please consult your financial advisor before investing.

Like us on Facebook and follow us on Twitter. Diversification reduces asset-specific risk — that is, the risk of owning too much of one stock such as Amazon or stocks in general relative to other investments. So diversification works well for asset-specific risk, but is powerless against market-specific risk. Finally, cash in a savings account can also give you stability as well as a source of emergency funds if you need it. If you want to expand beyond this basic approach, you can diversify your stock and bond holdings.

For bonds, you might choose funds that have short-term bonds and medium-term bonds, to give you exposure to both and give you a higher return in the longer-dated bonds.

For CDs, you can create a CD ladder that gives you exposure to interest rates across a period of time. Some financial advisors even suggest that clients consider adding commodities such as gold or silver to their portfolios to further diversify beyond traditional assets such as stocks and bonds. And if all this sounds like too much work, a fund or even a robo-advisor can do it for you.

A target-date fund will move your assets from higher-return assets stocks to lower-risk bonds over time, as you approach some target year in the future, typically your retirement date. Similarly, a robo-advisor can structure a diversified portfolio to meet a specific goal or target date. Diversification offers an easy way to smoothen your returns while potentially increasing them as well. And you can have a variety of models for how diversified you want your portfolio to be, from a basic all-stock portfolio to one that holds assets across the spectrum of risk and reward.

How We Make Money. Editorial disclosure. James Royal. Written by. Bankrate senior reporter James F. Royal, Ph. Edited By Brian Beers. An average is always less volatile than its components. It is not always possible to know the precise correlation of one asset class to another.

However, financial planners often recommend that you have different asset classes in your portfolio. For example, you might include cash or equivalents , stocks or stock mutual funds, bonds or bond mutual funds, real estate, etc. It is generally accepted that such broad classes of assets help reduce portfolio volatility.

If you are able to identify your investments' correlations, then you can go the next step, which is asset allocation to build an efficient portfolio. Remember though, even by diversifying and following an asset allocation model will not assure a profit or protect against loss. Diversification across asset classes is another way to help reduce portfolio risk. It can help improve your potential for investment success. Diversification can help reduce risk from an investment portfolio by eliminating unsystematic risk from the portfolio.

By choosing securities of different companies in different industries, you can lower the risks associated with a particular company's "bad luck. However, diversification can reduce the return of your portfolio as well.

By selecting several assets, the overall return on your portfolio will be the weighted average of the returns of those assets. In one year, the stock has a total return of 30 percent, the bond 6 percent.

The portfolio return will be only 18 percent 36 divided by 2. However, if the entire portfolio were invested in the stock, the return would have been 30 percent. Many investors feel that settling for a lower average return is a small price to pay for reducing risks for which they cannot be rewarded unsystematic risk from their portfolio.

Of course, in practice these extremes, while possible, are rare. Diversification reduces portfolio risk by eliminating unsystematic risk for which investors are not rewarded. Investors are rewarded for taking market risk. Because diversification averages the returns of the assets within the portfolio, it attenuates the potential highs and lows. Diversification among companies, industries, and asset classes affords the investor the greatest protection against business risk, financial risk, and volatility.

When they say, "Don't put all your eggs into one basket," they're talking diversification. Identify, perhaps with a financial advisor, a range of investment options suitable to your goals. Create a diversified portfolio of investments that is likely to provide the greatest return in keeping with your risk tolerance. This content was created in partnership with the Financial Fitness Group , a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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