Analyzing the risk/reward trade-off
Beginner Stock Market Investing, Stock Market Investing Advice
This is the trade-off that will determine how comfortably you are able to sleep at night with your existing investment portfolio. While some people have a high propensity for risk and comfortable with high-risk investments, people who are more averse to high-risk investment sometimes wake up in the middle of the night in a cold sweat. It is therefore very important for you to build a portfolio that the level of risk that is in consonance with your personal comfort levels.
Technically speaking, risk is the chance that the actual return on your investment will be different (for better or for worse) and then the return that you had anticipated. Statistically, this is measured by standard deviation and there is the possibility that you can lose some or all of your money. A low level of uncertainty (low-risk) is associated with a low level of returns and similarly a high uncertainty level (high risk) is associated with a high level of returns. All investment is therefore a balancing act between the lowest possible level of risk and the highest possible level of returns. You should also keep in mind that the levels of returns can also be the level of losses. There is absolutely no guarantee that a higher level of risk will result in a higher level of returns. Instead you may be looking at a higher level of losses.
One way to balance of risk and reward is to build a diversified portfolio. Diversification smoothes out the risk by allocating your investment either between different investments or between different asset classes. This way, an adverse change in the price of one investment does not have a significant impact on the value of your entire portfolio. There are plenty of complex formulae that can be used to calculate this but a simple example will suffice. There are two companies one of which make raincoats and therefore flourishes during the rainy weather. The other company makes sun block and flourishes during the sunny season. If you split your investment between the two companies, your diversification will ensure that you earned some returns in any form of weather conditions.
According to the experts, there are three things that you can do to achieve the optimum diversification:
- Vary the securities in which you are invested by the nature of the industry as well as the nature of the sector. This will minimize the influence of risks that are associated with specific industries or sectors
- Vary the kind of securities in which you are invested. If you restrict yourself only to blue-chip stocks, you are minimizing your potential upside. Instead if you spread your investment, you are increasing the chances of gaining on an upside while limiting your losses on the downside
- Vary the asset classes in which you invest and spread your investments across different vehicles such as stocks, bonds, commodities, mutual funds, ETF’s and possibly some real estate. This will mean that you are diversifying away from investment vehicle specific risks.
Another question that puzzles a lot of investors is how many stocks you should hold in your portfolio to achieve the best diversification. According to portfolio theory experts, around 20 stocks are best. This assumes that you buy stock lots of different sizes across different industries. What you must always bear in mind is that diversification is no guarantee that you will not lose money but only a comfort is that the loss will be affordable.
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