Sunday, 4 November 2012

A Great Way To Reduce The Risk Of Your Portfolio

Rule No.1: Never lose money.              
   Rule No.2: Never forget rule No.1       -Warren Buffet 
I was surfing the net where I found this quotes its seems be funny but makes sense a lot in the investment world …Making money is not that much easy in stock market but not that much difficult it’s an interesting affair, but only if we don’t lose some on the way. However, in all probability we may lose in some case, causes can be various. Investing in equity requires skill, knowledge and the courage to accept defeat at times.

It’s necessary to identify the companies you want to invest in, understand their nature and, if possible, discern their balance sheets. Now, all this does not require special degree or qualifications but a cursory glance will give you a broad picture. Another fact to remember you must monitor and review your portfolio every once in a while.
Diversification ……. What and How??
Division of investment in different asset class is called diversification. In the world of investment it’s the fact that diversification is only way to reduce the risk of the portfolio. In diversification we can cover the loss of one sector with the profit of other sector. Division of investment should be based on the probability of return on that sector.
Now let’s understand how:-
Look at this simple example Say, there are two companies where you want to invest X and Y. Both are have a potential return of 15% and a standard deviation (a statistic which measures the variability (i.e. risk) of the potential returns) of 25%. Also, the returns of both these companies are uncorrelated i.e. the performance of company X is dependent at all on the performance of X company Y.
Now assume you invest equally in both these companies. Your weighted potential return (0.5*15%+0.5*15%) will equal 15% this is the same return as that for the individual company. However, due to the fact you have now spread deviation (i.e. risk) of your portfolio will be 17.63% (lower than the 25% for each individual company).
It is important to understand what this means.
You would have been able to reduce the risk profile of the returns on your portfolio to 17.63% (from 25% for an individual company) without having to compromise on your returns, merely by diversifying. So, by choosing two assets whose returns are not correlated(this is important) like say stock X which is a Banking company and Stock B which is a FMCG company, We can reduce our risk by keeping constant returns.
Two things that are important to keep in mind while planning your investment.
  • Every asset has a risk attached to it. Yes it’s true that every asset has a risk attached to it and it’s also fact that higher the risk higher will be your return. Identify your risk apatite and start investing accordingly.
  • Put your eggs in different basket. This Statement implies nothing but the diversification of the investment in different sector. It has been rightly said that “Never test the depth of the river with the both feet” in investment term we can understand this concept this as not to put all our money in one sector. It is better to identify the different sector on the basis of return and give the weight of your investment to those sectors accordingly.
To sum up this I would like to express few more things on investment which is necessary to consider. There are various sectors to invest like Stock (Banking, IT, FMCG, Manufacturing, Real-estate…etc), Funds (Mutual fund), Property, and Commodity market (Gold and Silver…etc). Do your own research identify the sector and invest your money to that sector where you feel more return with less risk.

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