Risk and return come hand in hand. One cannot have one without another. This is the rudimentary law of investing, with aim to maximise returns while managing all the risks involved. As such, an investment's potential return is proportionate to its potential loss. How much stock can appreciate would also mean that on the flip side, there is also a chance it could become worthless as well.
With that basic understanding of risk, it can be further classified as 2 groups of risk namely: Diversifiable and non-diversifiable.
As literal as it is, these 2 kinds of risk are being managed differently. One is able to be diversified and minimised, while the other is not. Diversified risks refer to anything specific to a company, industry, market, economy or country; it can be reduced through diversification. On the other hand, non-diversifiable risks like inflation rates, exchange rates, interest rates, political instability cannot be avoided by mere diversification.
That brings us to the question: Why do we need to diversify our portfolio? Does it work?
Diversifiable risk can be diversified away by constructing portfolios of unrelated assets. It will be the most effective when the returns of the individual securities are inversely correlated. Lower the covariances, the lower the portfolio risk it becomes. With that, the expected outcome becomes manageable within a specific risk appetite, along with a certain degree of reasonable returns as well.
Unfortunately, there are no ways to avoid non-diversifiable risks. Given the overall environment, uncertainties as well as instabilities, such risks may strike unexpectedly. Regardless of how well a certain portfolio is diversified when a certain global event strikes, it will affect all asset classes of different spectrums. Likewise, diversification does not remove or reduce such risk. Thus rendering diversification ineffective in such a context.
Still, even with the existence of non-diversifiable risks, investors should still opt for diversification. To illustrate this; the total risk is the summation of diversifiable and non-diversifiable risks. By opting for diversification, it reduces the total risk by lowering and minimising the diversifiable risk portion. As a result, the overall risk is reduced.
From another perspective, in some contexts diversification may not work effectively at all. It does remove risks involved, yet that will also mean that the potential returns will be reduced as well. Should the investor or fund manager have certain insights in a listed company or an industry, and he or she is extremely confident in it, he should act on it to capitalise on it to maximise the opportunity fully.
To further elaborate the above, diversification may and may not help in the above case as there are 3 possible outcomes:
If the insight is true, diversification failed to achieve the aim to maximise returns.
If the insight is false, then diversification helps to soften the losses by reducing the exposure from the start.
If the insight is true, but some unexpected events happened to result in an overall negative outcome, then diversification helps to mitigate the uncertainties involved.
Depending on the type of risks involved, diversification works to a certain extent. It should be combined with fund management’s foresight, judgment and related experience to navigate better through the intricacies of risk and chance.
On an ending note, diversification helps to minimise the expected risk to a certain extent only. It works to ensure portfolio aims are met with manageable risks. Therefore only by combining with other means, it helps to ensure better execution of investing to manage risks in hopes of maximising the returns.
As this is the last post of the year 2021, SGSAS would like to wish all readers and followers a happy and safe 2022!
