Diversification is the best risk management plan and the single most important element of investment management. Diversification is a portfolio strategy that reduces risk by combining different investments that are not correlated. The volatility (risk) of the portfolio is reduced because not all asset groups, industries, or stocks move together.
One of the goals of proper diversification is to reduce unsystematic risk. Unsystematic risk is risk that is specific to an individual investment and can be nearly eliminated by diversification; this includes company specific risk, poor fund management risk, industry risk, and market risk.
Diversification Rules
A risk management plan should include diversification rules. These are mine:
5% Rule – Never Put More Than 5% in Any One Stock
Company specific risk is risk that is specific to the individual company and not to outside risks like the stock market or the companies industry. Company specific risk can be nearly eliminated with diversification. Owning a variety of companies lowers company specific risk and provides investment diversification. Investors should never put more than 5% of their portfolio in any one stock. This is especially applies when the company is the investor’s employer. Holding a large percentage of an employer’s company stock exposes the investor to losing their job and their retirement portfolio if the company experiences fraud or difficulties.
15% Rule – Never Put More Than 15% in any One Mutual Fund or ETF
Fund management risk comes from owning mutual funds or Exchange Traded Funds (ETFs). Even the best mutual fund managers or indices (many ETFs follow specific indices) fall on hard times and surprise their investors with poor performance. Investors should not put more than 15% of their portfolio in any equity mutual fund or ETF.
25% Rule – Never Put More Than 25% in any One Industry
Industry risk is the risk of an entire industry doing poorly. The perfect example of this was the 1999-2000 period when technology stocks became the favorite of institutions and individuals. Many mutual funds and individuals invested most of their assets in this one industry. When prices cratered in 2000 many lost the majority of their investments due to lack of diversification. Investors should not put more than 25% of a portfolio in any one industry.
Systematic risk is the risk associated with market returns. Market risk can be diversified away with financial hedgin. Easily traded inverse ETFs move opposite of the market, or even double or triple the inverse of a particular index. Investors should understand how these instruments work and their pitfalls before purchasing these financial instruments.
Related Reading on Risk Management
| AAAMP Blog by Ken Faulkenberry | |
|
Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record. |
 |
{ 2 trackbacks }