Managing risk: Understanding the subtleties of diversification
Written by Steve Ciaccio, MBA, CPA, CFP®
We know that sometimes there are economic events that affect the overall performance of the entire stock market. We call this market risk. Although diversification cannot protect against market risk, there are other types of risk that can be, to some extent, diversified away. Understanding the types of risks and the subtleties of diversification can help you make choices that are suitable for your needs.
One of the types of risk that can potentially be decreased by diversification is the risk that an individual investment can lose some or all of its value for reasons that affect only that company. We call this specific risk. Examples might be a product failure or the potential effects of a major lawsuit against that company.
There are several ways to categorize stocks to help you diversify against specific risk. One of the most well-known categories is the size of a company. In this case, we consider the size of the company to be the total value of all of its outstanding shares. This is often called a company’s market capitalization, or “market cap”. Many investors define large-cap as $10 billion and over. One description of mid-cap might be companies with market caps between $2 billion and $10 billion. A small-cap company might be between $300 million and $2 billion. Less than $300 million could be considered micro-cap. Some people might use different dollar amounts to define cap size, but you can see the general scale of this example. Remember that size is not always an indication of financial strength and diversification can sometimes be less effective when randomly adding investments. Therefore, knowledge of each company’s financial situation and future outlook is necessary for making suitable choices.
Another way to diversify is between “growth and “value” companies. Growth companies tend to reinvest their cash into new products and marketing to rapidly increase their sales and market value. Growth companies do not usually pay large dividends. Value companies are sometimes fundamentally strong yet tend to be priced lower than companies with similar situations and financial condition. The term “value company” does not guaranty that the stock is a bargain or that its price will increase. It is simply a name that is used for that situation. Similarly, growth companies cannot guaranty continued growth. Growth and value stocks come in all sizes.
Another way to diversify is to invest across time. Instead of investing a large amount of money at one time, you might consider investing that money in smaller amounts periodically over a long period of time, such as two years or more. Doing so has the potential to help you avoid investing large amounts at market peaks. The offset is that if your intended investments move up steadily over time, you might have missed opportunities to purchase at lower prices at the beginning. As you can see, there is risk in all aspects of investing.
Diversifying across multiple industries can be another effective way to reduced specific risk. Bear in mind that one industry can sometimes affect another. For example, prices in the fuel industry can often affect many other industries, and sometimes the entire economy. You might consider diversifying across all industries of the economy.
You might also want to consider diversifying across geographic areas, including investing in other countries of the world. Risks to consider when investing abroad include political risk, currency risk, and many other risks as well.
These are only a few of the many areas of diversification to consider and only a few of the many types of risk to protect against. Remember that diversification does not guaranty investment performance and does not guaranty against loss. You should always invest appropriately for your investment goals and risk tolerance. I recommend working with a reputable and capable financial planner for all of your financial planning and investment needs. In addition to receiving the appropriate professional assistance, having your own knowledge has the potential to help you make choices that are suitable for you.
All the best to you!
Steve Ciaccio, MBA, CPA, CFP®
Steve Ciaccio, MBA, CPA, CFP® is the founder of Ciaccio Wealth Management, Ltd., located at 232 South Batavia Avenue, Batavia. He can be reached at 630-454-4599, Steve.Ciaccio@LPL.com.
The opinions voiced in this article are for general information only and are not intended to provide specific investment advice, tax advice, or recommendations for any individual.
Securities and advisory services offered through LPL Financial, a Registered Investment Advisor. Member FINRA/SIPC.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
All investing involves risk including loss of principal. No strategy assures success or protects against loss.
Asset allocation does not ensure a profit or protect against loss.
Copyright Steve Ciaccio 2018