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The Basics of Controlling Risk and Diversification in an Investment Portfolio

By on October 1, 2020
Categories: INVESTING

When putting together a portfolio, investors can control the following four factors:

  • Risk
  • Diversification
  • Taxes
  • Costs

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

Risk

When referring to risk, we’re talking about the mix between risky assets (like stocks) and less risky assets (like bonds). One’s ability and willingness to take on risk dictates what mix of stocks and bonds makes sense for that investor.

Time horizon is a major factor that affects a person’s ability to take on risk.

For example, young people saving for retirement have the ability to take on higher risk because they don’t need to tap into their investment portfolio anytime soon. They have the time to be able to ride out market volatility and turbulence. As a result, young individuals will typically want to have more stocks in their portfolio than bonds.

On the flip side, individuals approaching retirement, who will soon need to start tapping into their investment portfolio, will need to take on less risk. As a result, that individual will typically have a higher allocation to bonds (relative to stocks).

Your Reaction to Risk

A person’s willingness to take on risk also dictates what mix of stocks and bonds will make sense for their portfolio. When referring to willingness, we’re talking about a person’s emotional reaction to volatility. For example, if someone absolutely can’t sleep at night due to fear of the stock market dropping, that person’s willingness to take on risk is lower. All things being equal, that person might have a lower allocation to stocks and a higher allocation to bonds.

Ultimately, a person’s ability and willingness to take on risk must be taken into consideration to come up with the appropriate mix of stocks and bonds in an investment portfolio.

Diversification

Investors can also control the diversification of their investment portfolio.

When it comes to an investment portfolio, one wants to incorporate investments that have different risk and return profiles (or relationships). By doing this, some investments will “zig “when others “zag” in various market environments.

Within an asset class like stocks, one can achieve a higher level of diversification by investing in companies based off various factors such as size (e.g., large, medium, or small-sized companies), geographic region (e.g., U.S.-based or international-based), and by sector (e.g., technology, healthcare, or financials).

An investor can invest in securities such as a single stock in a single company (like a share of Microsoft or a share of Apple) and a single bond like one Treasury bond (issued by the U.S. government) or one municipal bond (issued by a state or local government).

Choosing individual stocks or bonds, however, is missing the mark on diversifying. To increase your level of diversification, one could invest in broader groupings of stocks and bonds.

An investor can do that by investing in a mutual fund or an exchange-traded fund (ETF) that provides exposure to many investments. For example, one could invest in one mutual fund and own a piece of all the companies in the S&P 500.

The S&P 500 is an index that measures the performance of 500 large companies listed on stock exchanges in the U.S. The S&P 500 contains exposure to countless brand-name corporations such as Microsoft, Apple, Johnson & Johnson, and Visa.

There are other ETFs and mutual funds available that track other market benchmarks. Here is a small sample of the categories that ETFs and mutual funds invest in:

  • Small-sized companies
  • Medium-sized companies
  • International companies
  • Technology companies

ETFs and mutual funds make achieving a higher level of diversification much easier.

Learn more about Dowling & Yahnke’s overall investment philosophy here.

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