Capital Risk and Diversification of a Portfolio
Original post by Geri Terzo of Demand Media
Capital risk, which represents the likelihood that an investor will lose money, becomes heightened without the proper diversification. A diversified portfolio has exposure to various asset classes, which are investment categories, and possibly different regions of the world. The threat of losing money increases without proper exposures because in the event that one asset class falters, there is less of an opportunity for non-correlated investments to compensate for any losses.
Certain asset classes expose investors to greater capital risk than others. Economic conditions can also dictate which categories are riskiest. Stocks, for instance, have the potential to be highly volatile and may trade in extreme directions. Bonds, which are a type of fixed income investment, can be reliable, consistent investments that deliver steady but modest returns. Greater diversification protects an investment portfolio from excessive losses but inadequate exposure to the some risk could interfere with profits.
Large and small investors can use portfolio diversification as a means to control risk. According to a 2011 article in "Investments and Pensions Europe, HBOS," a subsidiary of Lloyd's of London, sought to reduce its risk exposure by investing in additional asset categories. A subsequent article in "Institutional Investor" confirmed that the pension pursued investments in infrastructure and reinsurance investments, which are alternative assets. In 2010, stocks and alternative investments generated returns of 8.3 percent for the fund.
There is no exact science to predicting stock market activity. Market technicians, however, are able to identify major trends. Commodities, which are financial contracts tied to agricultural, energy and financial products, are an alternative asset class that perform in a non-correlated fashion to equities, according to Index Universe. Subsequently, diversifying an investment portfolio to include asset categories that do not tend to respond similarly to events, such as equities and commodities, could mitigate capital risk.
According to an article in USA Today, diversifying an investment portfolio is a sound way to mitigate capital risk but it will not eradicate any vulnerabilities altogether. This is because there is an inherent risk associated with investing and it's tied to changes in the economy. The only way to near completely erase capital risk might be to keep money locked up in a savings account, but in doing so an investor may also miss profit opportunities.
- Index Universe; Inside ETFs European Conference; 2010
- "USA Today"; Diversification Can Lower Your Risk, Not Eliminate It; Matt Krantz; July 2008
- Investments and Pensions Europe; Lloyds Pension Schemes Look to Diversify Risk Investment Strategy; August 2011
- Institutional Investor; HBOS Pension Plan Hires Fund Managers; August 2011
About the Author
Geri Terzo is a business writer with over 15 years experience reporting on Wall Street. Her coverage ranges from institutional investing, including hedge funds and investment banking, to family topics and her career experience includes work for Fox Business, CNBC and "IDD Magazine." Terzo is a graduate of Campbell University, where she earned a B.A. in mass communication.