Mutual Fund Investors: Expanding Their Overall Diversification Potential

With the increasing scrutiny on financial markets, certain mutual fund investors are wondering how they could better diversify away from risk while still earning great returns for their portfolio. While there are certain strategies that investors can undertake to minimize their risk, there is always the risk that the market as a whole is unhealthy and produces negative returns. In any case, this article will outline the different types of risk inherent with investing and how to avoid them.

Systematic Risk

This type of risk is impossible to reduce through diversification. Unfortunately, along with investing in capital markets comes the risk of an overall economic downturn. Since this risk is impossible to eliminate, mutual fund investors tend to focus on the next main type of risk: non-systematic risk.

Non-Systematic Risk

This type of risk is the risk associated with investing in any particular security. This can be a stock, bond, exchange traded fund etc. Fortunately, this risk can be reduced through diversification. As such, many mutual fund investors search to choose a wide variety of securities to include in the portfolio in order to diversify away from this non-systematic risk. However, it must also be noted that after a total of 32 securities are added to the portfolio, the risk has been diversified as much as possible. Any securities that are added to these 32 will not serve the purpose of reducing risk in the portfolio.

Diverse Security Types

Now that we have covered the forms of risk and the need for diversification, we can cover some of the ways to expand proper diversification potential. The first is to invest in different types of securities. Depending on the business cycle, different securities will be most appropriate to the portfolio, however there should always be a mix of these securities so that the investor is not restricted to one particular market. Different security types that some mutual fund investors consider are: bonds (also called debentures in some cases), equities (stocks), exchange traded funds (these follow the performance of a certain market whether it is a stock market or the market for the price of a metal). More experienced investors may choose to invest in stock options or warrants which essentially give the right but not the obligation to purchase a security at a given price.

Diverse Industries

Another strategy to increase the diversification potential of a portfolio is to invest in a diverse number of industries. This will prevent you from being overly exposed to an industry which may experience an overall decrease in profits due to a certain global issue (i.e.: the real estate market). The key here is to invest in stocks that aren't correlated to one another. For example, rather than investing in a cruise company as well as an airline company (both subject to variance in the amount of travel); you should invest in an airline company as well as oil. Since the price oil is negatively correlated to the airline company's profitability (as one rises in value the other should fall), you will be well positioned to reduce the overall risk of your portfolio of securities.

While there are other methods of diversification (i.e.: investing in foreign markets), these are the main ones, and by using this knowledge, you should be able to minimize the risk in your portfolio greatly.

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