Managing risk and diversification in an investment portfolio

The degree of success we achieve from our investments is sometimes beyond our control. For instance, macroeconomic and geopolitical issues are two significant factors that impact market performance. However, when putting together an investment portfolio, in our experience, investors can largely control the following four factors:

1. Risk level
2. Diversification
3. Taxes incurred due to trading
4. Costs

In this blog, we’ll look at the first two factors: risk level and diversification.

1. Risk level

When referring to risk, we’re talking about the mix between more-risky assets (like stocks) and less-risky assets (like bonds). Your ability and willingness to take on risk dictates what mix of stocks and bonds makes most sense for your circumstances.

Time horizon is a major factor that affects a person’s ability to accept investment risk.

For example, young people saving for retirement can often take on higher risk because they generally don’t need to tap into their investment portfolio anytime soon. They have the time to be able to ride out market volatility and withstand short-term losses with the knowledge that markets tend to rise over time. As a result, young individuals will typically want to have more stocks and equity-based funds in their portfolio than bonds, in order to pursue long-term capital growth.

On the flipside, individuals approaching retirement will soon need to start accessing cash from their investment portfolio, so they’ll usually need to take on less risk because they don’t have the time to recover from a steep market decline – even if it’s short term in nature. As a result, that individual will typically have a higher allocation to bonds and other fixed income securities (relative to stocks).

Gauge your reaction to risk

A person’s appetite for accepting risk also dictates what mix of stocks and bonds will make sense for their portfolio. When referring to appetite for risk, we’re talking about a person’s emotional reaction to volatility. For example, if someone absolutely can’t sleep at night because they fear a sharp drop in the stock market, that person’s willingness to invest in riskier securities is lower. All things being equal, that person might choose to have a lower portfolio allocation to stocks and a higher allocation to bonds.

Ultimately, each person’s ability and inclination to accept a certain level of risk must be taken into consideration when arriving at the appropriate mix of stocks and bonds in an investment portfolio.

2. Diversification

Investors can also control the diversification within their investment portfolio. When it comes to a portfolio, investors often want to incorporate securities that have different risk-and-return profiles (i.e., relationships between the amount of risk taken for the amount of return expected). By doing this, some investments will “zig “when others “zag” in various market environments, which should help dampen volatility and “smooth out” portfolio returns over time.

Within an asset class like stocks, you can achieve a higher level of diversification by investing in companies based on various factors, such as market capitalization (e.g., large-, medium- or small-sized companies), geographic region (e.g., U.S.-based or international-based) and sector (e.g., information technology, health care or financials).

An investor may choose to invest in securities like a single stock in a single company (e.g., one share of a bank), or a single fixed income security like one Treasury bond (issued by the U.S. government) or one municipal bond (issued by a state or local government).

Selecting individual stocks or bonds, however, is missing the main point and benefit of diversification. To increase your level of diversification, you should consider investing in broader groupings of stocks and bonds.

You can achieve diversification by investing in a mutual fund or an exchange-traded fund (ETF) that provides exposure to many investments. For example, you might invest in one mutual fund and conveniently own a piece of all the companies held in the S&P 500 Index – something that would be extremely difficult, if not impossible, to accomplish on your own.

The S&P 500 is a popular index that measures the performance of the 500 largest companies listed on stock exchanges in the U.S. Exposure to many companies across various asset classes, sectors, industries and geographical regions is typically an effective way to enhance long-term returns and reduce relative risk.

There are many other ETFs and mutual funds available that track a number of market benchmarks. Investing in ETFs and mutual funds can make achieving a higher level of diversification much easier, which may help your portfolio generate stronger performance with less volatility over time.

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