Risk mitigation through diversification
Risks are a constant in the world of investment. They cannot be eliminated. But, there are strategies to minimise them.
How to reduce investment risk? Investment risk can be reduced by risk mitigation strategies to ensure that the end goal is not adversely affected.
How to manage investment risk? Risk management can be adequately managed through a fundamental component of in investment approach. It is needed to improve investment outcomes. The right strategy keeps losses within an acceptable boundary during hard times and helps to cover up losses during good times. Diversification is one such time-tested risk mitigation strategy. Here are some tips to diversify investment risk.
What is diversification?
Diversification is a means of managing an investment portfolio. Through this one can invest in a wide range of financial assets. So, even if a certain set of your assets do not perform well, it can outweigh the declining performance of the rest of your portfolio. Diversifying balances out and reduces the overall risk associated with a portfolio. Every asset performs differently based on the prevailing market conditions. Diversification is all about investing in various non-related assets to balance out the risk exposure. Non-related assets are assets like equity, bond and gold, whose performance does not depend on each other.
Some assets are also co-related to each other’s performance. For example, equity markets tend to slump during an economic downturn. During such times, the Reserve Bank of India (RBI) tries to stimulate economic growth by lowering interest rates. As interest rates start to fluctuate, co-related assets such as bond prices also tend to go up and down. Thus, equity and debt are inversely correlated to some extent.
In short, diversification simply refers to ’don’t put all your eggs in one basket’. Instead of investing in a single investment avenue, you can invest in multiple financial assets such as stocks, bonds, mutual funds and real estate etc. Moreover, you can also choose to diverse the investments within the same asset class.
For example, you can invest Rs. 10 in different shares of varied sizes, industries and sectors. In doing so, you are at a minimal risk of loss in the event of a fickle market environment.
Thus, a well-diversified portfolio helps you in the long run by spreading out the risk of an asset and minimising overall investment risk, thus helping you to pursue your investment objective. Here it is important to note that though diversification effectively reduces overall risk, it cannot completely erase it.
*The table suggests that the average risk of the portfolio reduces with the rise in the portfolio size.
How to diversify investment risk?
- Spread your investments across different assets. The risk and return profile of each asset class could vary. Equities are riskier than bonds. Hence, choosing a proper mix of less, moderate and high risk investment avenues can also help in diversifying as per your risk profile and time frame to achieve investment objective. Every asset class responds differently to economic changes. Therefore, figuring out the right mix based on your investment plan is the key to diversification.
- Consider different assets within the same asset category. To build a diversified equity portfolio, buy 15-20 stocks across varied sectors. Opt for negatively correlated stocks. For example, you can choose to invest in shell stock (oil production companies) and airlines (oil consumer) as the price of these company shares are negatively correlated. Negatively correlated stocks perform better if the other one drops, i.e. contra performance. Thus, diversification helps in averaging out the returns so that if one asset class does not perform well in a timeframe, the other one would make up for it.
- Remember diversification is an ongoing process. You need to constantly review your portfolio and rework on your diversification strategy based on your current need and situation. A disciplined approach can help you survive the ups and downs of a volatile market.
- Take expert help. Seeking help of financial experts can help you in building a well-diversified portfolio. Financial experts can help in designing a diversification strategy that can effectively reduce risks and maximize your potential returns in the long run.
Conclusion
In a nutshell, diversifying your investment among various asset classes protects you against significant losses by mitigating risks. Follow an asset allocation strategy as per your risk tolerance, investment goals and financial circumstances. Diversify among and within various asset classes to reduce risks and achieve your financial goals. Get guidance from a financial professional on asset allocation and diversification for your portfolio. IndiaNivesh expertise in the field can help you mitigate the risk through diversification to achieve your financial goals.
PREVIOUS STORY
Why some assets are riskier than others
Be it stocks, mutual funds, bonds, exchange-traded funds or real estate, there is an element of risk in all types of investment. The only thing that separates them is the degree of risk. In order to understand this better, let’s look at factors such as investment risk management, investment risk and return etc., amongst others that determine the risk level of each investment option. Factors that influence risk element of each assetWhat is investment risk? The risk level of each asset is dependent on its characteristics, investment horizon and behaviour (the way an asset reacts to change in overall market, political and economic environment, interest rates etc.). • Level of volatilityVolatility indicates how rapidly the value of an investment asset can change in a specific time period. This is why stocks are considered volatile. That’s because share prices can change several times in a short time. This means that you can either make a large profit or lose a large chunk of your investment in a short time. A fixed deposit, on the other hand, is less volatile because its value doesn’t change intermittently. This is why fixed deposit returns you receive are fixed. • Time horizonDuration of an investment can determine the risk level as well. For example, a short-term equity investment can be risky because its value changes constantly. But when it’s held for a longer period of time, various studies show that equity is a high-performing asset class. That’s because the price of equity usually flattens in the long run. There is a sense of stability in the long run. Meanwhile, debt investments are relatively safe for short- to medium-term goals. That’s because they provide steady returns if not kept for very long. They can be a long-term investment option as well but the returns may not be able to beat inflation. This is why people usually opt for equity over the long-term and debt investment for a shorter time period. • Nature and characteristicsYou also need to look at the nature of an asset class (equity, debt and gold are some examples of an asset class). Let’s take the example of stocks again. Owning shares of a company means you own a part of their business. You are entitled to company’s profit. You are also expected to bear the loss. This is why stock investments can be a high-risk, high-reward investment. On the other hand, investing in bond means lending money to an entity (it can be a government or a corporate) for a defined period. The chances of losing your money in such cases occur only if the company or the government default. • Asset behaviour towards economyRisk can also be assessed by particular asset’s behaviour towards prevailing economy. For example, market value of bonds reduce with an increase in interest rate and vice versa. Equity investments also get impacted by everyday price movement, industry performance and many other factors. • Individual investor’s risk toleranceIn the end, everything boils down to an investors’ ability to take risk. For example, investing in equity can be a risky proposition for a retired person because they usually look at an asset class that can provide them a steady source of income. In contrast, the risk appetite of a younger person is usually higher and may opt for equity. That’s because they can absorb the short-term volatility and wait for the investment to potentially provide high returns in the long run. To sum upEvery financial asset has a degree of risk. Understanding the nature and level of risk helps you manage those risks effectively to pursue your financial goals. This is why IndiaNivesh can offer you specialised solutions to achieve your financial goals.
NEXT STORY
How to measure risk?
Risk is inevitable and natural. It affects every investment decision you make as an investor. There is no solution to escape investment risks. Your best hope is to manage risk effectively. What is a risk assessment? Well-managed risk is beneficial in the long run, as risk and return go hand in hand. Hence, risk measurement is a kind of risk assessment procedure which is the first step towards making a wise investment decision and building a well-managed investment portfolio. Let’s understand the types of risk assessment.Types of RiskRisk can be of two types:- Qualitative risk- Quantitative risk Qualitative riskThis type of risk is based on these factors: Financial goals Time horizon Risk tolerance capacity The risk of the investment itself How to do a risk assessment? The nature of the investment and its historical performance need to be considered in order to analyse the risk. This can help you compare different investments too. For instance, you have two investments. The investment that has steadily given you a return of 10% year on year is considered less volatile and risky. On the other hand, the second investment gives fluctuating returns, 14% one year, 4% the next year and 10% hereafter. Here, the second investment is considered volatile and a high risk investment option. Quantitative risk assessmentBesides qualitative approach, risk can also be quantified using analytical tools. Thus, in quantitative risk management, risk is calculated on the basis of certain formulae. Some of them are:• Standard deviationIt’s a commonly used statistical tool for measuring risk. Basically, standard deviation is used as a measure of volatility in stocks, stock portfolios and mutual funds. This number indicates how much a particular stock/fund return has varied from its average return over a number of years. An investment is considered risky if its return deviates more from historical averages. For example, stock A and B have given an average return of 10% for last 5 years. But stock A is more risky than stock B as its standard deviation is more and the stock is highly volatile. Let’s take a look at the performance comparison of the above table in a graphical manner below. The standard deviation graph suggests that stock A is prone to fluctuations as compared to stock B. Alpha Alpha measures investment performance on a risk-adjusted basis. Basically, Alpha means the excess return for any investment as compared to its benchmark performance, thus keeping the risk under adjustments. Therefore, Alpha of more than 1.0 implies that an investment has outperformed its benchmark and compensated more than that of the risk taken. Beta Beta gives an idea of historical volatility. It is used to measure how a stock or a portfolio moves in comparison to benchmark index. For example, beta 2 implies that a particular asset is twice as volatile as the benchmark. Beta shows how sensitive an asset is to market movements. R-squared R-squared helps you gauge to what extent the investment portfolio movement reflects on the benchmark movement. The figure may vary from 1-100%. A higher percentage denotes good correlation between portfolio and benchmark return. Sharpe ratio Sharpe ratio is one of the widely used tools in tracking the performance of an asset. It is a risk adjusted measure of return that helps to compare two similar investments. In mutual funds, two funds are compared on the basis of Sharpe ratio. The fund having a higher Sharpe ratio is considered worthwhile. VIX (Volatility Index) VIX is a widely used measure of market risk. It was introduced in India in 2008 by the National Stock Exchange. VIX measures near-time or upcoming risk. It is based on future and options data and hence gives an approximate idea of near-time volatility expected in the market.ConclusionIn a nutshell, a correct blend of both qualitative and quantitative risk measurements is ideal for performance assessment and to construct a healthy investment portfolio. It is always good to use more than one mathematical measure to analyse risks. Risk measurement techniques are useful in evaluating the risk associated with an investment, thus helping you analyse and compare to make a smart investment decision.
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