Diversification – Lightning Strikes or Asteroids

Risk

This is the word that has us reaching for the insurance application, the second medical opinion, and a good hard look at what the share market is doing. But what do we really mean by risk in an investment context?

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Specific risk (getting hit by lightning)

When we talk about specific risk in investing we mean the kind of risk that only affects a certain type of investment. If we invest in oil, and there's a sudden reduction in oil use due to a global pandemic, then we are affected by specific risk pertaining to the commodity we're investing in. In the same way if we buy a lot of shares in a particular company and there are problems related to the management of that company, then we're affected by specific risk. The risk is specific to that company, that commodity, that industry or sometimes even that country or geographical area. We only take the hit because we're exposed to that particular risk.

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Market risk (getting hit by an asteroid)

Then there's market risk, which is the kind of large event which affects the whole market. It's not just the oil companies being affected, but everything at once. Sometimes this even affects other asset classes; the Global Financial Crisis of 2008 affected not only the share markets but also the price of real estate in Australia. It's very hard to avoid if we're exposed to the market at all, and even if we aren't directly, then there are usually flow on effects which hit us in other ways, such as supply shortages or increased unemployment.

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Diversification

So how do we deal with risk? With lightning we can avoid going outside when it's stormy, or not standing on a hill while flying a metal kite... the usual. It's harder to avoid being hit by an asteroid so having a plan for reducing the impact is important. When we're investing the standard way of reducing risk is to diversify our exposure. If we're only invested in one geographical location or one industry, then anything negative in that area will hit us hard. If our investments are spread over a number of industries then it's more likely that a downturn in one area might be offset by an upturn in another, and our overall position will be not so bad. Diversifying our investments across a wide range of industries, geographical areas and asset classes is often the most effective way to reduce our exposure to risk.

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Diversifying against specific risk

Whether our investments are in property, term deposits or shares, specific risk can be reduced if we don't put all our money in one thing. If we invest in property, diversification against specific risk might mean buying investment properties in different suburbs, or apartments in different buildings. Our specific risk is going to be high when all our apartments are in the same block of flats, for example, as a structural problem with that building in particular will create a significant problem. We can spread our holdings across different industries and countries when purchasing shares and ETFs so that a problem with one area doesn't affect our whole portfolio. Although ETFs, being a bundle of shares, are more diversified than a share of a single company, thematic ETFs, like Cloud Computing or Artificial Intelligence are not as diversified as index ETFs based on the top market performers or other broader market segments.

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Diversifying against market risk

Market risk is much harder to beat, because everything gets affected at once. Very often the best way to diversify against market risk is to diversify across different asset classes. Not all asset classes are affected in the same way by market events. This means that having both property and shares in our investment portfolio might reduce our exposure to a property slump, or a share market crash, because the other class of assets isn't so badly affected. In many cases market risk is simply unavoidable and needs to be waited out.

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Conclusion

Alas, none of these strategies work perfectly and risk is always going to be a part of investing. Diversification is one thing we can do to reduce the likelihood of catastrophic losses. Time is another great way to reduce our exposure to risk and we'll cover that in the next blog.

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* The information provided in this article is general information only and does not take into account your objectives, financial situation or needs. Before making a financial decision, please assess the appropriateness of the information to your individual circumstances and consider seeking professional advice.

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