How do you reduce your trading risk?
Diversification is a risk strategy that aims to minimise risks and exposure to the market. By investing in assets that are diverse and different from each other the idea is that.
In general all assets are subject to two types of risk. Systematic and unsystematic risk, diversification is a process for decreasing a portfolios exposure to unsystematic risk. Systematic risk is the risk associated with a market, and unsystematic is inherent of a company or even industry.
Diversification in investing has been around as long as investing has itself, the concept might have been similar but the principles have always remained the same. In 1952 Harry Markowitz introduced the Market Portfolio Theory which he later was awarded a nobel prize for. We’ll spend some time going through his work but essentially he developed a mathematical framework such that the expected return on a portfolio is maximised for a given level of risk. In other words he managed to figure out how to maximize profits depending on how much risk you want to take.
How To Diversify
- Speak to a financial professional
- Research, investigate and analysis different financial assets
- Invest in a wide variety of different companies across industries
- Consider foreign financial assets
- Diversify in bonds
- Consider property and REIT’s (Real Estate Investment Trust)
- Look into mutual funds
- Index funds
- ETF’s (Exchange Traded Funds)
The list can go on and on, but it is always important to talk to a financial expert before making any financial plans.
Minimising risk of loss – Having investment across a multitude of asset classes means that if one of your assets in a class were to dramatically reduce in value, your portfolio would not be as significantly impacted if that was your only asset, by not concentrating your fund in one area you minimise potential risk and therefore potential losses. This concept adheres to the “don’t put all your eggs in one basket’ rule that has been told for generations. Diversification is nothing new but that doesn’t mean it isn’t essential.
Preserving capital – Not all investors want a rapid accumulation of wealth, some investors particularly those close to retirement age want a stable and reliable source of wealth and income that will not change in value too drastically. As a result for those people often the best option is to heavy diversify so as not to be as susceptible to huge market changes
Generating consistent returns – Investments dont always provide consistent and reliable returns, and returns often fluctuate over time. In order to gather any sort of consistency diversifying can balance income out to be a more reliable figure.
Diversification doesn’t really hold much ground if that assets you are investing in are significantly similar to each other. The Markowitz portfolio theory explores the math behind the correlation of assets and the benefits to return. Put simply the more different the better, it can reduce risk whilst maintaining return, or even reduce risk and increase return. However if you are considering diversifying with very similar assets because that market is doing again you should rethink your approach.
Warren Buffet has been vocal on diversification for a while now, and many investors agree with him. That diversification for the sake of diversification is not always a smart choice. The argument lies with the quality of investments. Let’s look at the stock market for example. If we wanted to diversify in that market we would pick maybe 20 well performing stocks from different industries, we would obviously do more than that but the idea is there. The problem is that in the stock market there may not be that many great companies that we can invest in. There may only be a small handful that we truly believe in, understand and are profitable. So why should we waste our resources on worse performing companies, and thereby sacrificing greater returns with the other companies? Warren Buffet speaks on this in the video below