Variation is a fact of investment life. The asset class that provides the strongest return in one year is likely to be overshadowed the following year—or the year after that. The same is true of asset subclasses. In some years small caps outshine large caps. Other years the opposite is true. By owning both, you boost the potential for greater overall gain.
Most securities have two types of risk: systematic and nonsystematic. Systematic risks affect an entire market or asset class. An example of interest rate risk is that almost all recently issued bonds lose market value when interest rates rise. Likewise, currency risk affects all non-US investments, whose return is vulnerable to the changing value of the dollar against the currency in which the investment is denominated, or sold. And inflation risk reduces buying power when your return on investment is less than the rate of inflation. You can counter systematic risk with asset allocation, creating a portfolio of asset classes that are vulnerable to different risks, not all of which are likely to occur at the same moment. Bonds may suffer as interest rates fall, but stocks often excel. So does real estate. And that low correlation is exactly what you’re seeking.
In contrast, nonsystematic risks are specific to individual securities. The risks that fit into this category result from factors such as management decisions, the introduction of new technologies, and competitive products. You may counter nonsystematic risk with diversification. For example, if you purchased stock in one oil-drilling company; your return could be up or down depending on the success or failure of the company’s explorations or the production of the wells. But if you owned shares of an energy fund invested in dozens of oil-drilling companies, those that did well could at least offset and perhaps outshine those that did poorly. Then the primary risk would be systematic: the direction of oil prices
Contributions from the book Understanding Asset Allocation in this press release are used with permission from Light Bulb Press and sponsored by Medigap Central.