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Friday, February 11, 2011

Diversification of investment risk

Investment diversification is a type of risk management that used by investors and refers to the spreading of investment capital through multiple financial instruments and/or economic sectors. An example of diversification is stock ownership across a number of industries such as oil, utilities, biotechnology, retail etc. Diversification is similar to hedging in the sense that it is employed to lighten negative impacts from downturns on a specific financial instrument, economic condition/sector, and localized investments.

Many people diversify their money in different ways. For example, someone may put money into a house, have a savings account, own jewelry, use a money market account, hold certificates of deposit (CD's), and save through Individual Retirement Accounts (IRA's) or a pension fund. This is diversification in the sense if one or other of these investments falls through, there is another to relieve the overall risk to one's net worth. The hallmarks of diversification are listed below:

• Distributes money across an array of investments
• Shields investors from volatile fluctuations in prices
• Broader investment net may capture otherwise unrealized capital gains
• Allows riskier investments while simultaneously limiting exposure to associated risk

The following video outlines the risk reducing effect of investment  diversification: 

Diversifying through mutual funds

Diversifying risk is easy to do if one has tons of money to spread around. However, for those who don't have millions of dollars, mutual funds do. What's more, mutual funds often consider diversification an essential part of their investment strategy even if it is just within one economic sector.

For around the first 30 investments an investor or mutual fund makes, the level of risk declines significantly, especially if those investments are across different industries. However after a certain point, the lowering affect diversification has declines making the risk to number of investment ratio change less and less. A few ways diversification in the stock market takes place including through mutual funds are listed below:

1. Diversified Mutual Funds
2. Investment in international as well as domestic stocks
3. Time spread investments i.e. dollar cost averaging
4. Selection of stocks that span a number of economic sectors
5. Investment in large cap, mid cap as well as small cap stocks and pink sheets
6. Ownership of stocks, stock mutual funds and exchange traded funds
7. Diversification through investment in multiple stock exchanges.

Other types of investment diversification

Diversification can be achieved in a number of ways and at varying levels of risk. One can diversify through the methods listed above or one can diversify using multiple financial instruments. Some examples of this type of diversification includes the following methods:

• Low-risk diversification

1. Low risk mutual funds such as precious metals, utilities and bond funds
2. Treasury Bonds, Savings accounts, Australian Government Bonds
3. Investment through IRA's, Life Insurance Policies and Certificates of Deposit

• Medium-risk diversification

1. Investment in index funds
2. Diversification through middle capitalization and large capitalization companies
3. Capital investment in Bonds, stocks and higher risk mutual funds

• High-risk diversification

1. Investment across a range of small capitalization companies
2. Diversification through a number of risky exchanges such as foreign exchange, futures and growth sectors of the economy.

Risks typically associated with non-diversification

When one does not diversify, one's net worth can decline dramatically. An example of this is the Tech bubble of the late 1990's and the Housing Bubble of the middle 2000's. If an investor had all their money in either of these industries after the bubble burst they could have lost a great deal of money.

An economic 'bubble' does not have to burst for an asset class or industrial sector to have a correction of 10-20% because there are many integrated market forces that drive prices of financial instruments outside of abnormal pricing. While diversification does not eliminate all one's investment risk, it can present some very safe options depending on how risky the investments are.

How one diversifies is also important because as with any investment strategy there are many different ways to diversify. Some methods are better than others. For example, if one diversifies in secure and Government backed financial instruments one's risk will be lower than if diversification takes place through high risk stocks across a number of industries. Also the choice of investments one chooses to diversify with can create a combination of risk and return that is ideal for an individual investor.

In summary, investment diversification limits but does not eliminate risk. The safer the investments that are diversified, the lower the overall risk will be. Diversification can be achieved through mutual fund investing as well as through investment in multiple asset classes and financial vehicles. The benefits of diversification are well known and considered a beneficial investment strategy.