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Managing Risk with Diversification

When you invest, you have to be prepared for risk. The kinds of risk you face and the damage those risks can inflict depend on the combination of investments you make. While you can help limit risk with your investment choices, you can't eliminate it completely.

More baskets, more eggs

One way to manage risk is by using an investment strategy called diversification. Diversification means buying a variety of investments in different asset classes, choosing them both on their own merits and because, in combination, they may help you keep risk in check without significantly reducing return.

If you're trying to diversify your stock portfolio, you should look for promising companies in different sectors of the market, of different sizes, with headquarters in different places around the world. That's because companies with different characteristics tend to react differently to what's happening in the stock market and the economy at large. When you own a variety of stocks, an investment that drops in value may be balanced out by other investments that are doing well.

Big companies, or those that provide essential services, often do better in economic downturns than smaller companies, or those that sell nice-to-have instead of need-to-have products. Additionally, a foreign company may not be battered by the same forces or at the same time as a US company. You get the picture. What you want is for at least some of your investments to be doing well while others may be having a bad day - or year.

Variety is more than spice

Another reason to diversify is because no investment can be a winner all the time. Managers get it wrong. The competition gets it right. When things go badly, or if investors think there's trouble, lagging performance and a lower return typically follow. Not every company is apt to strike out at the same time. Every product doesn't fall victim to a newer one. But a well-diversified portfolio with a variety of investments may help you minimize serious losses.

A word of caution though, diversification doesn't guarantee you'll make money or that you won't lose any. But if you are diversified when markets are weak, that may help your return as the markets recover. And if you're diversified when markets are strong, you may be in better shape for the next downturn.

Here's another thing to keep in mind. Diversification can take time. You might not be able to create your portfolio overnight or even over a month or two. Consider defining the variety you want and how to get it. Then you can add to your holdings and weed out the ones that no longer fit your investment goals.

Safety in numbers?

So how much diversification do you need? And what's the best way to get it? You can diversify with a portfolio of individual securities, a group of mutual funds, bond funds, ETFs, or a combination of all of these. But the idea isn't to buy hundreds - or even dozens - of securities in each asset class. Even if you could afford to assemble a portfolio that big, you probably couldn't research or manage it effectively.

What's more, while it's important to diversify broadly, you want to avoid a lot of overlap. It's possible that three large-company mutual funds hold many of the same stocks, even if they use different investment styles. The same may hold true of three long-term government bond funds.

One approach among many for diversifying a stock portfolio might be to combine perhaps 15 or 20 large-company US stocks and a combination of funds or ETFs to cover small and mid-sized companies, particular market sectors that aren't already well represented, and international stocks.

No portfolio too small

If diversification, by definition, means owning a variety of investments to help limit the damage that any single investment or type of investment could do to your portfolio, what options do you have with a small portfolio and a limited investment budget?

One possible path is concentrating on mutual funds or ETFs. Both are already diversified in the sense that they own many investments. There are funds or ETFs that invest in every possible subset of an asset class. You'll want to be careful, though, about any fund that's narrowly focused and whether it could bear the brunt of any downturn in the overall sector where it invests. In fact, if you're just starting out, you might consider starting with a balanced fund, which invests in both stocks and bonds. Always remember, even with a diversified portfolio, you can still lose money.