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Diversification-An Effective Tool To Mitigate Risk

Updated on January 3, 2015
CliftonHRodriquez profile image

Clifton H. Rodriquez is a certified public accountant (CPA) by profession, but a passionate investment enthusiast.

Risk Will Always Be in the Market

Market risk is self explanatory. It is the risk that the overall market will decline in value due to a number of variables and factors. Every investor in the market accepts market risk as a given whenever they expose their capital. In a nutshell if the market goes up at some point it must come down. Why? Because the market consists of buyers and sellers. At any given point in time in the market, one class of investors will be more dominant than the other. If investors (i.e., sellers) are selling more risk assets (stocks) than other investors (buyers) are buying, or buying less than what is being sold, then the market will tilt south, or go into a "bearish" state. On the other hand, if there is a greater number of investors buying risk assets than those selling them, then the market will tilt north, or go into a "bullish" state. Most novice investors only get into the market when it is in this bullish state, but tend to panic when the market goes into a bearish state. There is no need for panic, if an investor clearly understands the dynamics of the market. To understand said market dynamics means that an investor accepts risk that comes with investing in the stock market.

Investors have to accept market risk, but do they necessarily have to accept company specific risk? Investors are not obligated to accept company specific risk. An investor can mitigate or lessen their chances of accepting company specific risk by merely vetting or thoroughly investing companies which stocks that they decide to buy. Company specific risk is directly related to the company itself, and can be easily avoided, or an investor need not expose as much capital to a stock, where that risk might be somewhat elevated. Even if an investors wanted to ignore both types of risk, is there an effective way to control or manage both?

Most investors have heard about or practiced diversification most of their lives. The common proverb that many investors have heard over the years is "not to put all of one's eggs in one basket". In effect, this is diversification and is the most effective tool to use when dealing with risk assets. If an investor comes into a $100,000 inheritance and wishes to invest that money in a few risk assets. What would be the ideal approach? Invest the entire $100,000 in a single stock, or invest $10,000.00 in 10 different stocks? Again, if the investor followed the proverb, then, of course, the logical choice would be the spreading the risk of investing that $100,000 into the 10 different stocks. Of course, diversification would not protect entirely against market risk, but should provide adequate protection against company specific risk.

Diversification should be used by all investors to mitigate or lessen the fear of investing in risk assets. Using it will not necessary bring complete peace of mind, but during those times of market decline (bearish state), the pain of loss would not be as hard and intolerable. Solid blue chip American companies tend to hold their own during market downturns. They hold their own because investors tend to vet them thoroughly, and when the fear passes, investors tend to flock back to those companies, and drive the stock prices higher than they were before the downturn.

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