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These words - diversification and risk – get used a lot by investors and the media. Diversification usually means the risk reduction expected after combining assets whose returns don’t always move in the same direction at the same time. Risk means uncertainty about future investment cash flows.

Diversifying risk sources means constructing a portfolio so that sensitivity to risk sources varies across portfolio holdings. For example, fixed-interest bonds are very sensitive to the effect of changes in prevailing interest rates. On the other hand, ordinary changes in prevailing interest rates generally have less impact on common stocks.  Stocks, unlike bonds, are very sensitive to ordinary changes in corporate earnings. Therefore, combining stocks and bonds in a portfolio should help diversify sources of risk.

Here’s another way to think about how to diversify sources of risk. There are three main strategies for managing risk:

1)    Don’t assume risk: This means putting money in an investment ultimately backed by the taxing authority of the federal government.  Bank savings accounts and certificates of deposit come to mind. (Technically, these investments do not eliminate risk…they reduce market risk).

2)    Allocate assets to achieve diversification: This means putting money in investments whose returns don’t always move in the same direction at the same time. (Asset allocation does not eliminate risk nor does it protect against a potential loss in principal value; it has the potential to reduce risk).

3)    Use the claims-paying ability of an insurance company: This means using an insurance company to guarantee the future value or future cash flows produced by investments. Insurers guarantee investment values subject to their claims-paying ability.

None of these strategies is the best strategy. Not all of these strategies are suitable for everyone. Each has its benefits and costs. By using a combination of strategies, investors can potentially reduce portfolio risk.

It makes sense, in this volatile economic world, to consider all three risk-management strategies.

If you’re unsure exactly how to evaluate your risk sources or how to diversify them, please contact Greg for an appointment.

Contact Greg Today!

218-534-3243

218-828-2111

greg.hight@investmentcenters.com