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What Is Risk Diversification?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 21 November 2016
  • Copyright Protected:
    2003-2016
    Conjecture Corporation
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Sometimes known as risk spread or risk allocation, risk diversification is a process used by companies as well as individual investors to vary holdings in a manner that allows the entity to absorb losses on some assets by gains made with other assets. The idea is to arrange the holdings in a manner that makes it possible to overcome temporary declines in certain types of markets with increases found elsewhere. As a result, the overall volatility associated with the asset portfolio is kept within an acceptable range and allows the investor to see some sort of steady increase in the value of that portfolio rather than posting losses.

The general concept of risk diversification is very simple. Rather than investing heavily in one particular asset or type of asset, a portfolio containing a range of assets is incrementally created. For example, an investor who wants to balance holdings in the portfolio may choose to include some real estate, several stock options and a few bond issues and perhaps even allocate some funds to commodities or currency trading. By doing so, the investor creates a situation in which losses with one type of asset can be offset by profits generated by the other assets within the portfolio.

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Determining how to go about the risk diversification can vary, depending on the type of investment opportunities the investor wishes to pursue. Even within the scope of choosing to stick primarily with one type of investment, there is still the opportunity for some diversification. This means that if the investor prefers to focus mainly on stock issues, he or she may choose to purchase even or odd lots of stocks associated with several unrelated industries. With this approach, the investor may allocate percentages of the portfolio to stocks associated with a couple of retail firms, a software company, an entertainment company, and perhaps an oil company. Assuming that the diversity among the stock holdings is sufficient, the investor will be positioned to anticipate that if the value of the stocks associated with the oil company should decline slightly, the gains with the retail stock shares will make up the difference and possibly also allow the portfolio to increase in overall value.

There is no one right way to pursue risk diversification, although there are a few general tips. One has to do with choosing assets that present no more risk than the investor is willing to assume. Another important factor to consider is how well the investor knows and understands the market associated with each holding. In addition, each asset added to the portfolio should be investigated thoroughly so the investor can rest assured that the investment has the potential to generate returns and make it possible to move a little closer to the goals set for the portfolio. By achieving and maintaining the right balance of risk diversification within the portfolio, the investor can enjoy a steady flow of rewards even when the need to replace certain assets become apparent.

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