Diversification is a basic investing concept. It means, essentially: Don't put all your eggs in one basket. If your portfolio consists of one stock, you're highly exposed to risk, because if anything happens to the company behind that stock, your entire portfolio will be in danger.
Most investors understand this concept, so instead of buying one stock, they'll buy 20 different stocks from businesses in different industries. Unfortunately, this still leaves them open to diversification's little brother: concentration risk. Concentration risk means that your investments are concentrated in one category, whether that category is an asset class, industry, level of liquidity, or something else.
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Why concentration risk is a problem
Concentration risk exposes you to a higher level of risk just as surely as a lack of diversification does, but it's sneakier about it. That can make it very dangerous, because you may not realize you have a problem until you've already taken some losses.
Consider the aforementioned example of the investor with 20 stocks in his portfolio. He's definitely more diversified than an investor with a single stock, but he's still highly concentrated in stocks. If something happens to bring down the entire stock market -- say, an economic disaster like the crash of 2008 -- then his portfolio will take a potentially devastating hit.
That's why your best course of action ischoosing assets that will react differently to varying economic conditions. For example, when stocks go down in value, bonds typically go up in value (and vice versa). If you own real estate, its value will tend to fluctuate differently from either stocks or bonds, so that asset helps to reduce your concentration risk even further.
Concentration risk also applies to liquidity, which is the ease of converting an investment to cash. Cash itself is the most liquid of assets because you don't need to convert it to something else to spend it. On the other end of the spectrum, real estate is highly illiquid, because it typically will take months, or even years, to find a buyer and complete the sale. Choosing investments that have widely varying levels of liquidity is another way to protect your portfolio.
Spotting the correlations between assets that lead to concentration risk may be tricky, as they can be quite subtle. For example, let's say you own some real estate and you also own shares in a mutual fund. You may not realize that that mutual fund largely consists of real estate investment trusts (REITs), meaning organizations that invest in real estate. Any economic event that reduces the value of the REITs' propertieswill thereby reduce the value of your mutual fund as well.
How to beat concentration risk
Ideally, you want to create a portfolio of assets that will react in different ways to different events. Let's look at the important example of inflation and deflation. Inflation makes your money worth less than it used to be; ironically, this is a healthy economic condition, and the Federal Reserve typically tries to create a moderate level of inflation in the U.S. economy. Deflation is the opposite: It means that prices are falling as the dollar becomes more valuable, which puts tremendous strain on businesses and therefore on the economy as a whole.
Because the economy is either in a period of inflation or a period of deflation, and it can't be in both at the same time, you want assets in your portfolio that will react differently to inflation or deflation. If some of your assets gain value during inflation and others gain value during deflation, your portfolio will maintain its overall value whichever way the economy goes.
The best assets for different economic conditions
One of the best assets to have during a deflationary period is cash, because deflation causes dollars to gain value. Long-term bonds can also do well in a deflationary period because the Federal Reserve will typically try to halt deflation by lowering interest rates. If you have long-term bonds that are locked in at a higher interest rate, those bonds will be worth more as the interest rate drops.
During a period of moderate inflation, the economy as a whole generally prospers, and many assets prosper with it. Stocks, in particular, do extremely well -- after all, stocks represent ownership in a business, and businesses generally thrive amid moderate inflation. Fixed-interest debt can be a great "investment" during these periods because inflation typically goes hand in hand with rising interest rates. Thus, the mortgage you got at 5% interest is an even better deal now that interest rates are at 7%. Similarly, real estate tends to do quite well during inflationary periods.
Very high inflation, also known as hyperinflation, is not nearly as benign for the economy or for most investments. As inflation skyrockets, so do prices and interest rates. Consumers tend to buy less, since everything is significantly more expensive, and so businesses suffer. Commodities tend to rise in value as prices rise, so they will tend to fare better than other assets during hyperinflation. Gold is the traditional commodity to buy as an investment, but there are plenty of other possibilities.
Inflation is just one example of a factor that will affect your assets' values (although it's definitely one of the biggest). You can either do some research on types of assets and how they interact with various conditions, or you can enlist the help of an investment expert. In either case, you'll need to check on your assets at least yearly to make sure they're performing as expected and rebalance them as needed. That way, you and your portfolio will be ready for anything the world throws at you.
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