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Why you can't beat diversification to lower your investment risk

by , 26 September 2014

A whole host of different companies, large and small, make up the Johannesburg Stock Exchange.

A lot of investors put the associated risk of investing in a company down to its size. But just because a company is large doesn't mean that it comes with no risk.

So what's your best bet to reduce your overall investment risk?

Let's take a closer look…

The link between company size and risk

If you’ve ever invested in penny stocks, you’ll know that with their small size comes higher risks. But with that risk comes the potential of great returns.

Investors tend to view penny stocks as much riskier than their blue-chip counterparts. Generally speaking, this is correct.

The Top 40 Index on the Johannesburg Stock Exchange contains these blue-chip companies. They’re the companies with the largest market capitalisations listed on the market.

Interestingly, the name blue-chips comes from poker where the highest value chip is blue.

When things get tough on the market, these blue-chips tend to weather economic downturns better. But they don’t offer the potential that a penny stock might. In return for that, investors view them as safer investments.

Blue-chips aren’t immune to risk

But that doesn’t mean bad things don’t happen to them…

Take UK supermarket giant Tesco, David Thornton in Penny Sleuth explains. Over the last year, the company has shed nearly half of its value. And this is a company in a supposed defensive sector.

Or think about BP. This oil giant was doing just fine until the Deepwater Horizon oil spill in the Gulf of Mexico in 2010. That resulted in the share price plummeting and the company suspending dividends.

These examples illustrate that big doesn’t mean there isn’t any downside risk. So what’s the best thing to do for your investment portfolio?

How to minimise your investment risk

It all boils down to diversification. By having a diversified portfolio, you can benefit from decent returns over the long-term and reduce the company specific risks associated with individual shares.

The number of shares you hold is down to you. But a portfolio of 15 or so stocks in companies in different sectors should sufficiently diversify your portfolio.

So there you have it, why you can’t beat diversification to lower your investment risk.

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Why you can't beat diversification to lower your investment risk
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