One way in which risk can be reduced is to invest in a range of investments or, as the saying goes, “don’t put all your eggs in one basket”. This is commonly referred to as “diversification”.
Why does diversification work? Different investments tend to experience good performance at different times. By not having all your funds in one investment, poor performance by any one investment will tend to be compensated by better performance by other investments. In this way, the combined return from your investments is smoothed out over time i.e. your overall risk is reduced.
Bear in mind however that, as a general rule, risk cannot be completely eliminated, even through diversification. This is because some risks will tend to affect all investments, no matter how you combine them. This is sometimes referred to as “non-diversifiable” or “systematic” risk and generally includes the various market risks identified above.
On the other hand, “diversifiable” risk refers to factors that are more specific to a particular investment (e.g. the industry and specific risks identified above) and which can be reduced through diversification. Even by randomly choosing investments, diversifiable risk can still be reduced. For example, studies overseas have shown that diversifiable risk can be largely eliminated by holding an investment portfolio of around 30 different investments.
Risk can be reduced through diversification i.e. investing in a range of investments. Because different investments experience good or bad performance at different times, combining them will tend to smooth out your overall return. Diversification can be achieved by investing in: