Every investment involves a certain degree of risk; even the safest blue-chip stock or a robust government bond can take an unexpected turn. A wise investor will therefore always ensure that these risks are minimized through careful planning.
The first step in risk management is diversifying your portfolio. This may seem counter-intuitive when the markets are doing well. It’s natural to be reluctant to channel some of your funds into assets that may seem stagnant. However, diversification should be a key part of any long-term portfolio.
Here’s how you can diversify your stock portfolio.
Risk diversification is just another way of looking at a diversified portfolio. The latter is an investment management strategy in which we divide our investment between separate assets. Different assets carry different degrees of risk, reacting differently to a given event.
While some will remain stable, others could lose or increase in value. A mixed bag of assets therefore allows your portfolio to absorb the impact of an adverse event, ensuring that any loss is offset in whole or in part by other investments. Risk diversification is therefore a tactic to balance the maximization of returns and the minimization of risk.
Ways to diversify your risk
When we talk about asset diversification, we consider them across different markets and timeframes. Even within the same asset class, it is better to opt for a varied combination. Therefore, a portfolio should contain a combination of stocks, mutual funds, bonds, commodities, money market instruments and real estate. Here are some tips you can follow to diversify your portfolio:
Determine risk tolerance
Risk tolerance is the amount of risk you are willing to bear. It is distinct for each investor and is influenced by many factors, one of the most important of which is age. Young people generally have a higher tolerance for risk than someone in middle age or close to retirement. They can invest in riskier, but high-return businesses, knowing they have time to offset potential risks over time. On the other hand, investors in their 50s will be looking for a stable avenue to park their life savings.
Likewise, personal responsibilities such as a high number of dependents, personal expenses or debts can also lower your risk tolerance. Understanding your risk tolerance is the first step in risk diversification. People with high risk tolerance or aggressive investors will be willing to take on risky ventures for higher returns.
On the other hand, conservative investors will prefer lower volatility. Most people are moderate investors, falling somewhere in between.
Start with an emergency fund and insurance
Start diversifying risk by anticipating and creating a fund for financial uncertainties. The preferred means of protection against these risks are insurance, in particular medical insurance and life insurance. While investing in these two instruments may seem pointless if you’re young, starting life insurance early also gives you the advantage of lower premiums. Depending on your assets or your lifestyle, you may want to invest in other types of insurance, such as that for your property or your car.
At the same time, the long duration of insurance coverage may expose you to other uncertainties in the immediate future, such as the loss of a job.
The first step in an investment plan is therefore an emergency fund. As the name suggests, an emergency fund is meant to be used only in an emergency. It must be liquid, ie available when needed.
There are many options that allow short-term withdrawals as per your convenience. For example, money market securities such as treasury bills (T-bills) can be easily liquidated for quick cash flow. Mutual funds with a systematic withdrawal plan (SSP) offer the option of withdrawing from the fund on a specific date.
Risk diversification in asset allocation
Asset allocation is the distribution of your investment between different assets. Stocks and bonds are the best known. Stocks are considered more volatile, but with higher yields than bonds. Fortunately, there are plenty of other options to choose from that cover the full spectrum of risk. When we diversify risk in a portfolio, we select assets with different risk profiles, combining a risky business with a safe and stable option.
For example, cryptocurrencies have become a popular choice among many aggressive investors. He was seen as the dark horse that could win the race as he gains momentum. On the other hand, its future is still uncertain. Therefore, a potential risk associated with cryptocurrencies can be offset by parking part of your fund in secure options, such as G-secs like T-bills or commercial papers.
While this works to diversify your portfolio, avoid spreading yourself too thin. Unless you have a professional at your disposal to take care of your assets, your assets must remain manageable. You need to be able to track the growth of your portfolio and the fluctuation of each allocation, and take corrective action immediately.
Consider different time frames to diversify your risks
Diversification is not limited to asset classes alone. It also extends to the timelines of the various investments.
A long-term investment will necessarily contain instruments that will take months or even years to mature. However, it also locks your money for an extended period. A short-term investment in stocks or mutual funds ensures that part of your portfolio will mature at a shorter interval, freeing up funds that you can then reinvest or spend as needed. They can also be used as an emergency fund, as discussed earlier in this article. Ideally, your portfolio should contain assets that mature at different intervals.
know when to go out
A buy and hold strategy is generally the recommended path for long-term investing. In this passive investment strategy, an investor keeps the portfolio stable over a long period of time, allowing risks to materialize and the asset to mature over time. Although this is the preferred option and may protect you from knee-jerk reactions or panic, it does not mean complete passivity.
You need to follow your investments and the markets to understand how each is performing. You need to know when to cut your losses and exit. This is where the stop-loss strategy comes in. A stop-loss strategy is when you or your broker sells your stock when it reaches a certain level. So, if your stop-loss order is at 5%, your broker will sell the stock as soon as it drops to 95% of the original price at which you bought the stock.
Rebalance periodically to offset risk
Once we have a portfolio with diversified risks, you must maintain this balance throughout its lifespan. This means reviewing your portfolio at regular intervals to assess its performance. Two factors are considered when reviewing a portfolio, the asset and the risk profile of the investor. It is important to understand that the risk associated with an asset can change over time.
For example, a mutual fund that was once considered stable may later become volatile. Your own risk tolerance will also change with circumstances, decreasing with age or debt. On the other hand, it can also increase with rising income. Your portfolio needs to be rebalanced to reflect these changing priorities.
Risk is an essential part of any investment. It’s the other side of the coin that can upset the apple basket of a healthy portfolio. The best way to offset this risk is to diversify it in your investments. With careful planning, you can ensure that a strong wallet also remains secure. Since it is impossible to completely isolate any investment from market forces, risk management is the only way to minimize losses, while maximizing potential returns.