Risk and reward are a common term you associate with investing. Understanding the risks associated to any investment and the reward for that risk is paramount to your decision-making process as once your risk is understood, this then allows you to invest in ways to mitigate this risk and the most common strategy adopted is Portfolio Diversification.
Modern portfolio theory states that the risk for each individual stock has two components:
Systematic Risk: These are market risks that cannot be diversified away. Interest rates, recessions and wars are examples of systematic risks.
Unsystematic Risk: This risk is specific to individual stocks, such as a change in management or a decline in operations. This kind of risk can be diversified away as you increase the number of stocks in your portfolio. It represents the component of a stock’s return that is not correlated with general market moves.
Portfolio Diversification is the practice of building a portfolio with a variety of investments that have different expected risks and returns lowering your Unsystematic Risk exposure. By thoroughly diversifying your portfolios across many different asset classes, you can expect to achieve lower risk and lower volatility than would be the case with a heavily concentrated, un-diversified portfolio. Diversification is not a guarantee against losses but gains and losses will tend to be less dramatic while the average gain over the long-term will be higher when we are fully diversified.
Furthermore, by investing in each of the different asset classes we eliminate the risk that any individual company bankruptcy or asset class bear market will put your financial well-being at risk. That is why advisors and fund managers love diversification as it alters the balance between risk and reward in favour of reward.
At Jaaims we love Portfolio Diversification too and recommend that when choosing your portfolio, you balance your portfolio across different stock markets, sectors and equities. By diversifying your portfolio will ensure good exposure across multiple sectors and allow Jaaims to analyse a greater range of equities optimising your returns on a diversified basis. This will not only lower your unsystematic risk exposure but deliver a better returning portfolio overtime.