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Diversifying Your Portfolio


Identify Risks

Risk is the possibility of something happening contrary to the desired result. Anytime you make an investment, you take on a certain amount of risk. As it pertains to portfolio diversification, risk is the possibility that some of your investments will be worth less than what you paid for them when you sell them. In order to manage your risks, you need to first identify them. The two main categories of risk include systematic and nonsystematic risk.

Systematic Risk

Systematic risk is a type of risk that affects almost all companies alike. Some examples of systematic risk include: interest-rate risk, which is the uncertainty of changes in interest rates; inflation risk, which is the possibility that increases in the prices of goods and services will reduce your purchasing power; currency risk, which exists because currency exchange rates are not fixed and may affect companies doing business overseas; liquidity risk, which is the possibility that you will be unable to convert your investment into cash when needed; and, sociopolitical risk, which is the possibility that social or governmental instability will affect global financial markets. To protect against systematic risk, you should invest in securities that are negatively correlated; in other words, securities that react differently to the same stimulus or economic condition.

Nonsystematic Risk

Contrasted with systematic risk, nonsystematic risk is associated with particular products, companies and/or industries and only affects a narrow class of investments. Two subcategories of nonsystematic risk are management risk, which is the risk that bad management decisions will affect the value of a security; and, credit or default risk, which is the possibility that an issuer of a security will stop making scheduled interest payments or fail to return the principal of the investment when it matures. To protect against nonsystematic risk, you similarly spread your investments across a number of companies.

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