The Reasons to Embrace Risk

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives

Diversifying your investments limits risk, but too much diversification limits gains while not reducing risk any further. You need to embrace risk in both public and private companies to receive the returns you desire.

When diversification becomes “di-worsification”

Charles Dickens once wrote that virtue, carried to excess, becomes vice. If Dickens were a modern financial expert, he would be talking about portfolio diversification.

Diversifying maximizes potential gains and minimizes risk. But when diversification is carried too far, it becomes “di-worsification.” Having too many investments in a portfolio limits the potential for extra gains without adding any significant additional protection against risk. And yet, over diversifying is exactly what countless investors, and even advisors, are doing.

True diversification counterbalances assets that behave differently in different market conditions. By investing in assets with lower correlation to each other, advisors gain exposure to a cross-section of growth opportunities. This does not mean investing in multiple mutual funds that in turn hold hundreds of companies that span across the market. In fact, research from The Fundamentals of Investments for Financial Planning, published by The American College, explains that true diversification doesn’t require such a wide range of investments as someone may think: “Research has repeatedly shown that a relatively small number of stocks (about 30) is sufficient to obtain most of the risk-reduction potential of diversification.”

Another way to look at this is that when your portfolio exceeds those numbers, diversification’s benefits disappear – a portfolio becomes increasingly exposed to market volatility. In plain terms, the more of the market you own, the more your portfolio will simply mimic the market. The optimized balance between risk and return will vanish so that when markets go down, up or nowhere, your portfolio will do the same.

Don’t fear volatility in individual companies – embrace the risk

Certain companies are bound to be more volatile than others, which could lead to higher returns or conversely, bigger losses. However, advisors and investors should not fear the risks of owning individual companies that may be deemed volatile compared to a historically stable security. Essentially, these “risky” companies are the basis of how large returns are made. A portfolio needs about 30 companies to achieve a satisfactory level of diversification against market risk. For advisors who are trying to achieve higher returns, among those companies should be those that pose a higher degree of risk.

To clarify, when I say invest in risky companies, this does not mean we are gambling on companies. This means looking for generally smaller sized companies that are well-managed, have a strong business model, and have the potential to grow significantly. The “risk” is that we can’t know for sure that these companies are going to succeed. The companies I choose to invest in are not risky because they are poor companies; they are risky because they simply haven’t made it yet.

However, by taking this approach, you increase your chances of making greater returns. Not only can it be beneficial for an investor to take risks on smaller companies, taking risks is a key component of driving innovation and growth for the economy as a whole. All of the successful large companies in the market today, that some may say are the “less risky” securities, were able to achieve their success because at some point someone took a chance on them. Lastly, the temptation to try to eliminate risk can be more hazardous than embracing risk. By over-diversifying in an attempt to avoid risk, investors can make their portfolios less creative and resilient, ultimately eliminating opportunities for large returns, and doing little to shield them from market risk.