In a previous guest post, my friend Rich wrote a guest post about investing in Exchange Traded Funds (ETFs).  He mentioned that ETFs are an investing instrument that decreases the risk of the stock market.  Now, the question is, how does an ETF decrease risk?  This can be explained by the concept of diversification.  As Rich said, each ETF tracks a wide range of stocks.  Simply put, diversification means that you are not putting all your eggs in one basket.  Having exposure to a number of different stocks in one portfolio can help in that if the stock of a particular market or sector performs poorly, the other stocks could potentially counteract that poor performance.  An ETF provides diversification without the need for a large sum of money to buy a number of different invidual stocks.

Now, keep in mind, just because your portfolio is diversified, it does not mean that you are free from any risk.  You can never diversify away all types of risk.  There are two basic types of risks – systematic and unsystematic risk.  Systematic risk can affect a wide range of assets, while unsystematic risk impacts a small number of assets.   Systematic risk is sometimes referred to as market risk because it can impact an entire market.  Unsystematic risk is sometimes referred to as specific risk because it is specific to a certain number of assets.  For example, if the employees of a specific company stage a strike and the stock price tumbles as a result, this is unsystematic risk (specific risk) because this particular company was impacted by the risk.

Through diversification, you can only lower unsystematic risk and can never eliminate systematic risk.  This is because by diversifying your portfolio, you expose yourself to different asset classes or stocks.  If one or a few stocks are negatively affected by unsystematic risk, the other stocks are not impacted.  However, with systematic risk, the entire market is affected and  a large number of your stocks could perform negatively as a result.

The lesson here is that you always need to diversify your investments.  That means, spread your investments out between different asset classes.  Examples of different asset classes could be cash in a savings account, individual stocks, index funds, mutual funds, ETFs, CDs, treasury bonds, corporate bonds, international markets, different market sectors and many more.  If you do not diversify, you are not only exposed to the systematic risks, but also to the unsystematic risks.