Systemic risk, a risk factor you can never eliminate, contributes to portfolio risk. Systemic risk includes the risk associated with interest rates, recession, war and political instability, all of which can have significant repercussions for companies and their share prices. By their nature, these risk factors are somewhat unpredictable. While you may be able to determine the long-term trend of interest rates, you cannot predict the amount they will rise or fall. In most cases, the stock market will price in the anticipated change, long before the individual investor even considers it.
Also known as specific risk, it relates to the risk associated with owning the shares of a specific company in your portfolio. This risk you can control, or at least minimize. As you increase the number of different companies within your portfolio, you essentially spread the risk across your portfolio, thus reducing the overall impact of an underperforming stock.
Diversification, or not putting all your eggs into one basket, is the primary method to reduce specific risk within your portfolio. Not only do you need to own a number of different companies, but you also need to own companies from different sectors. If you invest all of your money in bank stocks, you may reduce the impact one company will have on your money, but you have not eliminated the effect the sector could have on your investments.
More Than Just Stocks
A further way to improve your portfolio diversification is to invest in other asset classes. Balanced mutual funds invest a portion of the fund's money across stocks, bonds and short-term cash investments such as treasury bills. By adding these investments, which have a higher degree of safety and provide income, you also reduce your portfolio risk.
Understanding Your Risk Tolerance
Having a clear understanding of your tolerance to risk is a significant factor in achieving your investment objectives. It is easy to ride the wave of a stock market that grows every day with no end in sight, but it is an entirely different story when a crash or a prolonged period of daily losses occurs. Understanding your comfort level during these times helps in eliminating the possibility of making a rash decision at the wrong time.