Rules of the Game: Diversify Away Risk

 | Jun 28, 2013 | 2:00 PM EDT
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I've been writing about the need to understand the risks in investments, and particularly in trades. But how can you ascertain the risk of any given investment?

There are a number of risks that are obvious to the naked eye, and some that are hidden and require a bit of thought. The more apparent risks are known as "systematic." Loss of purchasing power, interest rate fluctuations and market volatility are among systematic risks.

As if that wasn't enough to be concerned about, there is also company -- or industry -- specific risk. Fortunately, you can use diversification to smooth out this kind of risk.

Here's an example: A client recently asked about making a small, "fun money" investment into the three-dimensional printing business. He asked about Stratasys (SSYS) and 3D Systems (DDD). We suggested one for his discretionary portfolio (which we don't manage, for what it's worth), but most definitely not both.

It may seem like a common sense move to diversify away some risk by not owning both, but I heard a story recently about an investor who actually holds both companies.That's a little too much exposure to a piece of bad news that takes down the entire industry.

This is why a balanced portfolio is one of the best ways to diversify away risk. Using the modern portfolio theory, a diversified portfolio begins with foreign and domestic equities, various market caps, corporate and government bonds of various durations and some cash on hand to make quick buys, if necessary. You want to avoid high correlation, but it has been true recently that many asset classes have tended to move in tandem for extended periods of time.

Nonetheless, bonds and stocks reflect inverse moves enough of the time to allow investors to sell one asset class that's topping out, and buy the other at bargain prices.

The level of diversification brings me back to an idea I explored in Thursday's column: Risk tolerance. Be careful when it comes to this concept.

I recently met a guy who organizes informational events for individual investors. He was telling his group that investors should expect a 12 to 15% return from a conservative portfolio. In what universe?

This kind of advice is dangerous, and sadly, is not uncommon. Many investors greatly overestimate the amount of risk they should be taking. Much of the overestimation is due to panicking:  A person hits 50 or maybe 60, and realizes he hasn't saved enough for retirement. Time to amp up the risk factor, right?

Not entirely. Each portfolio has to match its financial plan, not represent a drunken buying spree of high-beta stocks -- often accompanied by frequent trade to "beat the market."

To the extent that the panicked traders can give themselves some time, their portfolios will likely benefit. The standard deviation of the average rate of return on investments -- a measure of risk -- tends to diminish over time.

In other words: Calm down, get a financial plan and then get a balanced portfolio hand-tailored to achieve the objectives set forth in that plan.

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