Thursday, January 15, 2009

How to Manage Risk in Investments ?

Diversification:
Investments need to be made to get much better returns but keeping the risk to the minimum. The well know established fact of reducing the risk is through diversification.
  • Diversification across different asset class - equity, debt, commodities,real estate
  • Across geographies - different city, different country
  • Across different securities - different stocks , different bonds, different FDs
  • Across Maturities - short term, medium term, long term

Portfolio of securities

Investment in stocks is usually advisable to have investments in number of stocks rather then one single stock. The stocks should also be from different sectors and sectors should also be not related. If you 10 different stock but all from IT pack then if the IT sector goes down your entire portfolio will go down. so all stocks should be deversified across different sectors be IT, real estate, FMCG, OIL and Gas, Auto , manufacturing, commodities etc.

Note: Over diversification in stocks is also not good. If you diversify too much then returns will also be average your portfolio will then not outperform the markets.

Ideally for an individual investor should limit number of stocks between 5 and 30.

Risk Reduction through Product Diversification

It is important to have product diversification like direct equity, indirect equity through mutual funds, balanced fund, debt - corporate and government, fixed income like small savings scheme,Bank FD, PPF, post office term deposit.

Risk is in the portfolio can be reduced throught investments in different products in pre-determined proportion depending on the risk profile of the investor. The proportion should be managed periodicaly atleast once in six months.

Risk reduction through Time Diversification

when investing in equities it is an established fact the individual investor cannot time the market. Most of my clients will say the price of stock went down after he purchased it and whenever he sells a stock the price will go up. Rather then putting energy in predicting when the bottom is reached and when it is peak it is better to invest in equities through SYSTEMATIC INVESTMENT PLANS. All most all mutual funds have SIP facility to invest in mutual fund systematically and conveniently via ECS. Another strategy would be to park all your money in debt fund and transfer part of it regularly to an equity fund.

Hedging

Diversification reduces nonsystematic risk but systematic risk or market risk still exist. It cannot be diversified but systematic risk can be hedged.

Portfolio 50 Nifty stocks now this portfolio has dependence of failure of fortune for each company with a chance of 1 in 50. but if the market will swing each way then the portfolio will fluctuate with overall market. Now this risk cannot be reduced but hedged.

If your portfolio of 30 lacs and NSE nifty is trading at 3000 then 10 futures contracts of nifty can be sold to effectively offset the market risk. So if your portfolio decreases by 5% then the nifty contracts will increase by 5% as you have already sold it. hence your portfolio is immuned to market movements.

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