Portfolio Diversification: Types of Investment Risks

The key of reducing the risk is to avoid a portfolio where all the securities are strictly correlated with each other. If the correlation among the security returns is positive, meaning that the security returns move up and down in perfect unison, diversification is powerless when it comes to risk reduction. By mixing up diverse assets in your portfolio, you are less likely to experience major drops as they do not move and up down at the same rate and at the same time.

Portfolio Diversification, Types of Investment Risk

It is clear that owning ten stocks is better than owning a single one. However, there is a question bound to arise: how many stocks are necessary to reduce the risk through diversification? There are different viewpoints on this matter, however, the most common belief is that an investor can reach optimal diversification with 15-20 stocks. According to Modern Portfolio Theory it’s possible to achieve optimal diversity by adding approximately 20 stocks to the portfolio.

In their work “Modern Portfolio Theory and Investment Analysis” E. J. Elton and M. J. Gruber came to the following assumption: if the risk of a portfolio, including a single stock, was 49.2%, by increasing the number of stocks, the standard deviation (risk) would be reduced to a maximum 19.2%. Meanwhile, under same circumstances the risk of a portfolio containing 20 stocks was reduced to nearly 20%. Thus, the additional stocks ranging from 20 to 1,000 reduced the risk of a portfolio by about 0.8%, whereas due to the first 20 stocks the risk was reduced by 29.2% (49.2%-20%).

Types of Investment Risks

It is only natural that while choosing among portfolios sharing equal returns, investor selects the one with less risk. There are two distinct types of investment risks that an investor may face up to while investing:

  • Systematic risk – tthis type of risk also known as “un-diversifiable” is caused by macroeconomic factors like inflation rates, exchange rates, interest rates, wars and political instability. It is not peculiar to any company and cannot be reduced and not to mention eliminated by means of diversification. Investors can do nothing but accept this kind of risk.
  • Unsystematic risk – this type of risk which is also known as “diversifiable” is peculiar to a market, company, economy, or country and can be minimized through diversification. The main causes of the risk are financial and business factors, as well as the possibility that an investment or a category of investments will decline in value without having a major impact upon the entire market. Therefore, the objective of investing in different assets is justified as different assets are influenced differently by various market events.

The main reason why it’s not possible to reduce the systematic risk through diversification is that a drop in the whole market and economy has its direct impact on all investments. Therefore, diversification is aimed at reducing the unsystematic risk. If one has a portfolio composed of assets that belong to different classes, in case of unsystematic risk - when a single asset falls in value, other assets of various classes lower the risk of losses even if one investment type declines in value.

Nevertheless, there is no absolute guarantee of a complete profitable investment. Diversification does not ultimately prevent the loss; it can reduce the risk, the influence of fraud or bad information on the portfolio. General investment risks influence nearly the whole stock so it is important to diversify among various assets. The essential point here is to find the balance between risk and return; diversifying too much helps to avoid losses but it also lowers the chances for profit.