You can lessen your exposure to business and financial risk in your portfolio of investments through diversification, which is the purchase of different investment assets whose returns are unrelated.

For example, if you invest your savings of $1 million in the common stock of Intel Corporation on August 31, 2003, at $28 per share, a year later your loss would have been 25 percent of your investment. Intel stock fell to $21 per share. Intel’s stock performance was dismal when compared with the market for the same period, August 31, 2003 to August 31, 2004. The Dow Jones Industrial Average (DJIA) increased by 7 percent, the Standard and Poor’s (S&P) 500 Index increased by 8 percent, and the Nasdaq Composite Index was down by 1 percent for the same one-year period.

Suppose that instead of investing the entire $1 million in Intel stock for the one-year period, you decided to divide the money equally into 10 stocks. At the end of the oneyear period, your diversified portfolio would have increased by 6 percent as opposed to the loss of 25 percent from investing the entire amount in Intel. The gains in the portfolio came from aerospace, pharmaceutical, beverage, oil, and conglomerate stocks (Boeing, Johnson & Johnson, Pepsi Cola, ExxonMobil, and Tyco). The losses were due to Mattel in the recreational sector of the economy, Washington Mutual in the financial sector of the economy, Intel and Applied Materials in the technology sector, and Wal-Mart in the retail sector.

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The importance of diversification can be looked at in another way. With a portfolio consisting of one stock, a 50 percent decline in that stock results in a 50 percent decline in the total value. In a portfolio of 10 stocks with equal amounts invested in each stock, a decline of 50 percent in one stock’s value results in a 5 percent decline in the total value. Thus too few stocks in a portfolio means that you have too much risk placed on each stock. Too many stocks in a portfolio dilutes the potential upside appreciation in the total value of the portfolio.

By investing in a number of stocks from different sectors of the economy rather than investing in one stock, we have reduced our risk of loss. The returns on stocks from different sectors of the economy are not perfectly correlated, thereby reducing the variability in the returns. For example, the two technology stocks in the portfolio, Intel and Applied Materials, have returns that generally move together, a high correlation. Stocks from different sectors of the economy have returns that are not related, which means a low or negative correlation. By increasing the number of stocks in your portfolio to 30 or 40 that have low or negative correlations you can effectively eliminate all company-related risks. Thus, of the total risk, you can reduce unsystematic risk (operating, business, and financial risks) through diversification.