Question

How does the creation of a portfolio reduce risk? What type of assets should be included in a diverse portfolio? Why should they be included?

Answer 1

A portfolio is a group of various financial asset classes viz stocks, bonds, commodities, derivatives or any alternative assets. Various securities will have different returns. At broader level the returns are different across different asset classes. These asset classes returns have a relationship with other asset classes/broader markets. Some times their returns will move in the same direction. Other times it may be in opposite direction.

Further to this, risk is classified as unique risk (unsystematic risk) and market risk (systematic risk). Market risk, as we can see is that all the similar asset classes will be impacted by market fluctuations. Unique risk, however, is a security specific risk. It stems from security or asset class specific factors only. Ex - Research and Development of a new product, labour strike, new competitors in the industry, Goverment regulation changes, etc.

If you invest in securities with only one asset class, this leads to a high risk scenario. In a bearish market or a slow down, returns for all the assets may decrease and in turn the overall portfolio return will reduce. Example if there is any change in the government regulation, it will affect entire industry positively or adversely.

Within an asset classes, not all the classes get impacted equally during market turbulent times. Some may even show resiliency. So when you include different asset classes in a portfolio, even if there is a reduction in asset class returns, overall reduction may be less as compared to a single asset class portfolio. Example, if there is technological changes in any particular sector, all the securities within that sector may get affected however other sector, industry and asset classes will not be affected.

If you combine unique risks of such an asset class with another asset class, it will help offset the return variations. Ideal portfolio scenario is to include such assets so that in either of the market movement scenario there is always one asset class that is performing and can help offset the loss of the nonperforming asset class. In a diversified portfolio, unique risks of different stocks tend to cancel each other - a favourable development in one firm may offset an adverse happening in another and vice versa. Hence, unique risk is also referred to as diversifiable risk or unsystematic risk.