An investment’s risk suggests how much its actual returns could differ from expectations. Higher risk means prices are expected to be more volatile in the future with a higher chance of losses.
How much risk an investor should take on depends on their appetite for it, and their capacity to bear it. If you constantly check the value of your investments and a 5% yearly decline would cause panic, you probably have a low appetite for risk. The capacity to accept risk is higher for longer investment periods (since there is time to recover any losses made) and if additional contributions to an investment portfolio are possible, or if the portfolio is funding a low-priority goal.
To get to the point though, whatever the situation, an investor should be interested in reducing risk without reducing returns, and the good news is, this is possible.
The power of diversification
If you own just one stock, and that company goes bust, you lose everything. Each company has specific risks associated with its business: management can make poor investment choices, customers can abandon its products, or an explosion in one of its facilities could shut down production.
Investing in multiple companies dilutes this company-specific risk. However, holding the stocks of multiple banks would leave you exposed to industry risk, for example, new regulations could drag the profitability of all financial firms down. If investments are made in multiple companies that are in different industries, risk is reduced — when high street retailers are not doing well, healthcare companies may be booming.
Market risk will still be present, as the ups and downs of the stock market will also affect the value of the individual stocks in your portfolio. Investing in bonds will diversify this risk because the bond market has not traditionally responded to changes in the economy in the same way as the stock market. Investing in foreign stocks or bonds diversifies country risk.
Every investor should be able to reap the benefits of diversification by investing in stocks and bonds (or any investment product) whose prices do not move perfectly in step with each other (they are not perfectly correlated). The risk of the portfolio as a whole will then be less than the average of the individual risks: this is why diversification works, and it works best for uncorrelated investments, considered together and not individually.
Take 20 stocks with an expected return and risk being calculated for each, along with a measure of how their prices move in relation to each other, then various portfolios can be made by combining them in different proportions. An efficient portfolio would be one that has the highest return for a given level of risk.
If this sounds complicated, it is because it is! A financial advisor may be able to help, but if you do not want help or to do the calculations yourself, you will get closer to an efficient portfolio by investing in multiple quality stocks from different industries or even an index tracker — now that really is simple.
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James J. McCombie has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.