Every stock or asset that is purchased from an investor carries some type of risk. Market risk is the inherent risk that a stock or asset contains when purchased by someone. For example, recession, political turmoil, interest rates changes, natural disasters or terrorist attacks.

The same principle remains true with stocks: a certain company can have a devastating accident or problem, making the price of the stock tumble extremely quickly. A great example of this would be when one of China’s biggest real estate companies, Evergrande, defaulted on its debt. This made the company’s stock tumble rapidly, with the stock now experiencing very little volume.

Every stock and asset class is not equivalent, with each stock and asset carrying its own level of risk. Quantifying the level of risk of an asset is extremely tough, as it is mainly arbitrary: there is no financial model or statistical model that can determine with certainty the level of risk that a certain stock or asset carries. Therefore, it is very tough to determine the actual overall market risk that exists at any given time.

Considering that market risk will always be a consistent factor for any stock or asset class, can market risk be at the very least diversified? The short answer for this is no, as we mentioned before that every stock or asset carries some level of inherent risk. However, the long answer to this question is yes, market risk can be diversified to some degree by having a diverse portfolio that is invested in a multitude of assets and industries.

To answer this question, we will clearly define what is market risk, then we will observe some portfolios and strategies made by famous investors. Finally, we will give our conclusion about whether or not market risk can be diversified.

What is market risk?

Investopedia defines market risk very well: “Market risk is the possibility that an individual or other entity will experience losses due to factors that affect the overall performance of investments in the financial markets”.

This translates to the fact that any stock or asset carries systemic risk. From interest rate risks to commodities risks and currency risks, everything carries some sort of risk. People can elect to hedge themselves against this systemic risk. One could hedge himself by shorting the markets or purchasing put options.

A crucial factor to understand is that every investment class generally carries a different level of risk. Many investors see bonds as “safer” investments compared to stocks, however these bonds generally yield a less impressive ROI compared to certain stocks. The same is true about the commodities markets: they are considered by many investors to be less volatile than the stock market.

Related: Why Are Commodities And Oil Prices Soaring?

Example of a “diversified” portfolio

Ray Dalio is one of the world’s most famous investors. He has released many papers about the changing world order and macroeconomics in general. Ray Dalio is known for never going into full panic mode, and seizing opportunities in any market conditions. As the owner of a large hedge fund, he has developed the “all Weather Portfolio”: a portfolio that he considers to be perfectly diversified to be resistant to almost any market condition. Let’s take a look at what this portfolio is composed of:

all Weather Portfolio portfolio distribution

As you can see, the portfolio is 55% bond ETFs, 15% commodity ETFs, and 30% stock ETFs. By having the portfolio diversified across many assets, one can be to some degree protected from the price swings in the overall stock market. If bonds go down, perhaps stocks start climbing. If gold goes up in price and other commodities go down in price, the portfolio remains stable.

Ray Dalio’s all Weather Portfolio may be well diversified, however it still does not cover every market and every asset class. This all Weather Portfolio does not protect against currency deflation, meaning that if cash ends up being the best asset for an investor then the portfolio does not have any exposure to it.

That being said, the portfolio has exposure to many different industries and asset classes, which can help limit one’s downside if a certain asset class or industry completely tanks all of a sudden. The portfolio therefore does its best to limit the amount of market risk exposure, by owning a diversified portfolio.

Another well-known portfolio that aims to reduce market risk is the Golden Butterfly Portfolio. According to certain critics, this portfolio is actually considered a high-risk portfolio because it exposes itself evenly to all asset classes. The Golden Butterfly portfolio is composed of the following ETFs:

The Golden Butterfly portfolio

The Golden Butterfly portfolio focuses on gold, all bond sizes, and all stock sizes.Using ETFs, this portfolio gains exposure to almost every stock and asset class that exists. Some people see this portfolio as risky because it is over-diversified, meaning that perhaps it may struggle to grow in value over time unless there is inflation (when all assets rise in value). The even 20% allocation of each asset class may make some people feel like they are diversifying market risk, however.

So, can market risk be diversified?

There is a systemic risk in everything we do. Whenever we cross a street, we are technically at risk of getting hit by a car. When we go up a flight of stairs, we are at risk of falling down and getting injured. Systemic risks exist everywhere, and therefore market risk cannot be avoided. One cannot diversify or protect himself from systematic market risk, unless he maintains a hedge (through put options for example).

That being said, one can limit his market risk exposure by owning and maintaining a diversified portfolio of assets. If one industry asset class goes down, perhaps the other industries and asset classes go up.

A great example of the advantages of a diversified portfolio was during the recent stock market crash caused by the war between Russia and Ukraine. During this period, tech stocks listed in the Nasdaq suffered a loss, while oil and gas stocks experienced a surge. A well-diversified portfolio would have been less affected by the market crash, compared to someone who simply invests consistently in benchmark ETFs such as the SPY or the DOW.

Therefore, every investor is free to choose how much diversification he wants to give his portfolio. This may not necessarily eliminate market risk or diversify market risk, but it can protect one’s portfolio from extreme volatility. Therefore, how will you handle market risk?

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