Imagine for a second that our economy is slowing. Inflation is high, unemployment is rising, and the value of the dollar is not holding up as well as it should (This shouldn’t be too difficult to imagine). A stock like General Motors (GM) may not be doing so well because nobody is buying cars due to various economic uncertainties. But you own General Motors because you think it is a company that will deliver substantial gains over the long-term.
So to counteract the temporarily declining value of GM, you also own Heinz (HNZ). You own Heinz because they are a solid company that gains most of its revenue by selling ketchup. The state of the economy may be affecting the amount of people buying cars. But the economy has little to do with whether or not you are willing buy ketchup. You have just diversified.
Diversifying risk simply means balancing out the types of stocks in your portfolio in order to minimize the risks associated with positive and negative shifts in the stock market. Different types of stocks have different reactions to the overall movement of the stock market. For example, tech stocks are some of the most dynamic stocks out there because of their movement relative to the market as a whole.
In other words, if the overall market gains 5%, then a tech stock will most likely gain more than 5%. This also works the other way. If the overall market loses 5%, then it is fair to say that a tech stock will lose more than 5%. Anyone can determine the risk of a stock by simply looking at its Beta, which can be found easily and is usually located on the same page you would find the stock quote.
The Beta of a stock is a metric used to determine its movement relative to that of the market as a whole. The market has a Beta of 1.0, so when a stock has a Beta of 1.0, it simply means that the stock will move 1x the direction of the market. So if the market moves up 5%, then stock with a Beta of 1.0 will move up 5%. Tech stocks are more risky because they usually have Beta’s that are higher than 1.0.
This is where diversification comes in to play. We want high Beta stocks in our portfolio because when the market booms(goes up) the value of our high Beta stock will go up at a higher rate than that of the market. Say we have a high risk stock with a Beta of 1.5. If the market goes up 10% our stock is likely to go up 15% (1.5 x 10% = 15%) and vice versa. We want these more risky stocks in our portfolio to capitalize on upward shifts in the stock market as a whole.
We also want less risky, low Beta stocks in our portfolio to protect our money when the market is not doing so well. Say we have a stock with a Beta of 0.5 and the market goes down 10%. In this case our stock only loses 5% (0.5 x 10% = 5%).
The purpose of diversification is to find a balance that will provide a moderate level of security for poor market conditions and to provide potential for high gains when the market is flourishing. The higher the risk, the higher the potential return. It is important that any individual investor determine the amount of risk tolerable in your portfolio determined on factors such as age, expenses, financial situation, dependents, etc..
Think of a mutual fund as a portfolio of different stocks that a mutual fund manager has chosen in order to maximize return while minimizing risk depending on the specific funds objectives. This manager buys and sells different amounts of different types of stocks without the investor having to constantly be aware of where the overall market is headed.
Mutual fund managers will charge a fee to the investor in order for providing this service. It is important to research the manager(s) of a fund before investing in order to ensure that the he/she has a credible history.
Keep in mind that we have only considered the stock market. Other investments such as bonds, commodities(gold, silver, etc.), and Treasury Bills have different degrees of risk and potential returns associated with them. These should be used as vehicles for financial growth as well. A truly diversified investor is not limited to the just the stock market, but seeks an overall balance of risk and return consistent with that individuals specific investment strategy.