RiskMetrics - Diversification
Understand the benefits of portfolio diversification for long-run stability
Keep risks balanced
Savvy risk managers continually search out excessive concentrations in order to promote diversification and stable investment growth. Rather than mixing investments randomly, you can assemble investments which collectively perform well under different economic conditions, such as stocks and bonds (i.e., while stocks fare best in periods of economic expansion, bonds often do better in recessions).
The RiskImpact measure is useful for identifying excessive concentrations. Beware that the largest concentrations may not come from the largest positions or RiskGrades. In the sample portfolio below, Yahoo! has the highest RiskGrade (386), but SUN actually contributes more to the overall portfolio risk with its 31% RiskImpact.
You can also use RiskImpact to analyze how portfolio risk changes when you add new investments. Go ahead and see what if we bought $10,000 of NT (Northern Telecom).
Given the technology laden sample portfolio above, it should not be surprising that adding technology stocks such as NT increases risk much more than adding less correlated investments, such as bonds, diversified mutual funds, or traditional Blue Chips. For example, adding BA (Boeing) to the portfolio above only marginally increases risk and more than doubles Diversification Benefit.