Why does buying a diverse portfolio of stocks reduce risk?

Hi,

There are basically two type of risk. One is market risk and the other is non-market risk.

Market Risk are trade war, asian financial crisis, dot com crisis or global financial crisis. All these risk cannot be diversify or reduce by portfolio diversification because you got no control over it.

Non-Market Risk are risk that affecting the company that invested in. This risk can be reduce through portfolio diversification.

It reduces the risk because different factors will now affect the performance of your portfolio as compared to before. Hence, if an unfortunate event occurs, the impact on your portfolio will be lessened as Hariz has mentioned.

Basically you can diversify this risk away by developing a portfolio of varied asset classes from different industries and different fundamentals. But the cool thing is that you can actually cut your risk, but not cut your returns. This is what investors refer to firm-specific risk or diversifiable risk. By investing in a diversified portfolio, you are cutting this risk away, but your returns can still remain the same.

However, all stocks will be affected by market risk, which is the risk that all stocks will be exposed to across the market. This risk cannot be diversified away. In finance, we will only be awarded with higher returns when we take on higher market risk (measured by a firm's Beta), but not higher diversifiable risk.

I would say that the key here is in building a portfolio that are affected by different events. This could be economic, political, business or even geographic events. Hence, you should try to understand the fundamentals of your investments as much as you can.