JUN 1,2020 By: ATHUL RAJEEV, VENTESKRAFT
In this blog we will go through about risk and diversification. Most investment professionals agree that, although it does not guarantee against loss. Diversification is the most important component of reaching long-range financial goals while minimizing risk. Real diversification comes to a portfolio, if investments are allocated to different asset classes keeping in mind. The connection between them, including equity, bonds / debt fund, gold, real estate, etc.
Here, we ‘re looking at why it get relevant and how the portfolio diversifies. Diversification reduces risk by investing in various financial instruments, markets, and other types of investments. Investors may find it complicated and expensive to balance a diversified portfolio, and this may come with lower rewards. Because they mitigate the risk.
Investors confront two main types of risk when investing. The first of these is undiversifiable, also known as systemic or market risk. Every company is associated with that type of risk. Inflation rates, exchange rates, political uncertainty, war and interest rates are important factors. The type of risk is not financial sector-specific. And by diversification, it can’t eliminate or reduced. It’s just a possibility that investors will embrace.
The second risk category a diversifiable one. Also known as unsystematic risk this risk get unique to a business, sector, market, economy or region. Thanks to diversification it can developing. Business risk, and financial risk are the most common sources of unsystematic risk. Therefore, the goal is to invest in various assets so that market developments do not impact them in the same way.
WHY YOU SHOULD RISK AND DIVERSIFY
Let’s say you just have a portfolio of airline stocks. If airline pilots are declared to go on strike. And if all flights are cancelled, airline stock share prices will fall. That means that your portfolio will experience a major drop in value. Risk diversification is undertaken to secure the financial position of an organization. If a organization is not securing itself by diversification. Instead, it leaves itself subject to one aspect which may lead to expensive consequences. Diversification also means that you can look beyond your own regional limits for investment opportunities.
However, with a couple of railway stocks you mitigated the airline industry stocks, only some portion of your portfolio will get affected. There is probably fair possibility that the railway stock prices will increase, as passengers switch to trains as an alternative mode of transport.
However, as there are so many risks for both rail and air as each is involved in transport, you could diversify a lot more. An event that affects travel in some kind of way destroys companies of all kinds.
Over time, most equity-like instruments generate positive returns, but often display volatility. Avoiding the volatility is better than the alternative by attempting to time the market, which typically results in lower returns. A better approach is diversification of the portfolio which allows toleration of the volatility of any investment.
FOR AN EXAMPLE
We can say that rail and air stocks have a strong correlation. Therefore, you would want to diversify across the board, not only different types of companies but also different types of industries. The more uncorrelated your stocks are, the better.
It’s also important to diversify among different investors. Different assets such as bonds and stocks will not react in the same way to adverse events. A combination of investors will reduce your portfolio’s sensitivity to market swings. Generally, bond and equity markets move in opposite directions, so if your portfolio is diversified across both areas, unpleasant movements in one will be offset by positive results in another.
One of the major reasons against the closure of markets is that a market closure will further erode all investor confidence in a particular country. This will be caused due to the lack of transparency and data available to investors during the closure. In a time of crisis where investors are already panicking, a closure will only intensify their anxiety. This will increase the possibility of them selling out of the markets.
Volatility and risk are among investment realities. They can not be absolutely avoided but investors can reduce their portfolio effects. Diversification and hedging were the most effective ways of reducing risks and volatility. And greater the diversification of a portfolio across different types of investors and strategies, the less uncertainty can be that.