Every company or every asset that you invest into comes with the market and systematic risks. This could be because of inflation or changes in interest rates or even a war. The risk is not specific to any company. This can be minimized when one diversifies his portfolio.
Risk management can be achieved by diversification. Companies spread their own risk by selling many kinds of products and also selling globally. This lets them manage risks. Similarly, an investor can also manage his risks by diversifying his portfolio. When an investor diversifies his portfolio then a specific risk that is related to a particular asset gets offset by the risk of another asset.
Why should you diversify your portfolio to manage risks?
Diversification is not to boost the performance of your portfolio. It does not guarantee you any sort of gains or ensures you that there will be no loses. However if you have chosen the risk level based on what your goals are as well as your time horizon and what your tolerance to risk is, diversification can actually help to improve your portfolio and let you manage risks.
So in order to do risk management and to diversify your portfolio, it is important that your portfolio has a mix of stocks, cash, bonds, and other instruments. These are important because if you look closely then all these assets do not necessarily move in the same direction. You should also aim to have those assets which move in opposite directions. This will balance out in case a part of your portfolio is declining then there is another part that is making up for these losses.
Thus diversification lets you offset some of the losses.
Also, make sure that you do not over concentrate your portfolio with a single stock. If you are investing in stocks then you should diversify your portfolio into small, medium and large-cap stocks. The diversification should also be based on sectors. This is important because not all sectors or all geographies would move in the same degree and this lets you reduce the risk on your portfolio and also lets you spread your portfolio.
When you chose to invest in bonds then you need to have a portfolio that has invested in various maturities and durations. This will measure any sensitivity to the interest rate changes that impact the bond prices.
Diversification and risk management
When you manage risks you basically look to control the amount of money that you can afford to lose. As a smart investor, you thus should make sure to have a diversified portfolio and not put all your eggs in one basket. If you do not diversify then chances are that in case the stock or the sector that you invest into has some bad news then it could make you lose all your capital.