The power of diversification

Author: Forex Live | Category: Education

A lesson in managing risk

What if I told you that there is a way, scientifically proven, to decrease your risk when investing? Interested yet? Continue reading to discover an age-old way to invest and trade.

"It is the part of a wise man to keep himself today for tomorrow, and not to venture all his eggs in one basket." - Miguel de Cervantes

Scientifically proven, diversification can fundamentally decrease one's risk in their given portfolio, but it is important to note that diversification can only decrease one specific type of risk when investing, meaning there will always be risk present.

To explain briefly there are two types of risk, unsystematic (also known as diversifiable or firm-specific risk), and systemic (also known as non diversifiable, or market related risk) risk. By adding these two types of risks a trader may get the total risk involved.

Unsystematic Risk

As stated previously, unsystematic risk, also known as diversifiable and firm-specific risk, is the type of risk that an investor takes on that is tailored toward that specific industry or company, with the particular investment at hand. The most common factor for many investors that fall into this risk category is major company news from earnings statements,  changes of CEO's, and other major company specific fluctuations.

After defining the other major type of risk involved we will discuss how exactly a particular strategy can decrease this unsystematic risk.

Systemic Risk

This type of risk affects all competing firms and in-turn, will always exist. As much as we would like to dream, no trader can get rid of systemic risk, this is non-diversifiable and will always be present. 

A great example of recent events that affected the market which are categorized as systemic risk is the COVID-19 pandemic, or even the Suez Canal blockage last month. These are issues surrounding the global economy that investors cannot predict, or react to prior to the incident. Other systemic risk factor contributors are economics issues surrounding inflation, and interest rates, both of which are discussed frequently in the recent Fed meetings.

Although systemic risk will always be prevalent, non-systematic risk can be decreased by diversifying one's portfolio.

In the finance function, CAPM, also known as the Capital Asset Pricing Model, there are two portions of the equation to represent the unsystematic and systematic risk we have discussed previously. Simply, by adding additional assets to your portfolio of investments and diversifying, you decrease your exposed overall risk when calculating your estimated return on investment.

It is important to note that although this is a proven financial model, skeptics question its modern-day usage in today's fast paced financial world, where the numerical coefficients would be changing too rapidly to form any real type of conclusion.

Therefore, it is vital  to check if your investing platform provides the necessary educational resources, reporting and financial tools to help elevate your trading decisions to the best of your ability in order to capitalize and make major decisions to help find your portfolio a competitive edge, backed-up with a strong trading strategy.

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This article was written and submitted by eXcentral.

Disclaimer: This material is considered a marketing communication and does not contain, and should not be construed as containing investing advice or a recommendation, or an offer of or solicitation for any transactions in financial instruments or a guarantee or a prediction of future performance. Past performance is not a guarantee of or prediction of future performance.

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