Risks Involved in Buying More Than One Stock
Risk is a key part of the investment. Every investor must be aware of the risk-reward relationship which means that the risk in any investment is directly related to the reward the investor gets from that investment.
The riskier any investment becomes the greater reward it carries. For instance, junk bonds are risky investments which is why they carry a high rate of return, to compensate for the risk being taken on by the investors. Government treasury bonds carry a very low or zero interest rate which reflects the level of risk. Treasury bonds are very safe investments and therefore their rate of return is also very low, almost non-existent.
Risk, therefore, is a key part of any investment. The rate of return is partially comprised of the risk inherent in any security. For example, the interest rate of junk bonds is not calculated based on any guesswork. The interest rate on junk bonds reflects the probability of loss on that bond. Financial experts calculate the likely default on the bond and then they arrive at the rate of return that reflects the level of risk inherent in that security.
Risk therefore can be quantified, which means that when investors go for high-risk securities, they not only do so knowingly but do so to generate a higher return on their portfolio, the opposite is true for investors who go for low-risk securities.
This begs the question that why do investors have these preferences? Well, it all depends on the risk appetite of an investor. Investors can have a risk-averse or risk-seeking appetite. Risk-averse investors will be more conservative as compared to risk-seeking investors who like to take their chances. These are not strictly speaking polar categories, an investor can be both risks averse and seeking, it depends on what their investing aim is.
An investor can be risk-averse at one time and risk-seeking at other times. Risk is simply an ever-present factor when it comes to investment. It is up to the investors to determine what level of risk they want to get exposed to.
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Most investors like to keep their portfolios safe by minimising the risk that they are exposed to. Of course, because no one wants to have a highly exposed portfolio all the time. To do this, investors turn to the SARA or TARA method to manage or reduce risk, it stands for
- Transfer/Share
- Avoid
- Reduce
- Accept
This strategy is used by both companies and individual investors. Transferring or sharing of risk is done when the risk is transferable. For example, an investor may invest in a project jointly with another investor thereby sharing the risk of investment. Insurance policies are a good way of transferring or sharing the risk of investment.
Risk avoidance is practised were avoiding the risk completely is an option. For example, if an investor is offered a junk bond, they can say no if they do not need to invest further or earn a return. During the pandemic, many investors have taken their investments out of the market to avoid making further losses. This is a risk minimisation strategy.
Risk reduction is a very common strategy because it allows the investors to minimise the risk to a minimally acceptable level. Risk reduction is practised by diversifying the portfolio to reduce the risk.
Risk acceptance is practised where the investors have got no other option or where the risk is so low that investors can accept it even if the loss occurs.
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Portfolio Diversification
As mentioned above, diversification is a risk reduction approach that aims to diversify the portfolio. Diversification is achieved by making sure that the portfolio does not contain a lot of any specific type of asset. For example, it would be foolish to invest all of the savings into shares and bank on them. Why? Because whenever the stock market tanks, the shares will lose all of their value and the whole portfolio will therefore crash, resulting in a massive loss.
What many investors therefore do is that they carefully balance their investments between shares and bonds. Why bonds? Because bonds are considered as the opposite of shares when it comes to diversification. Generally, whenever the stock markets crash, investors take out their investment and invest it into bonds. Similarly, when the bonds drop their value the share market picks up.
Therefore if an investor achieves a 50/50 balance between equity and bonds then these can under most conditions balance each other out and the investors can minimise the risk of loss in this manner.
But equity and bonds are not the only two types of assets that one can invest in. There are other assets too such as
- Real estate investment trust shares
- ETFs/Index funds (basically equity assets)
- Gold and other precious metals
- Digital assets such as cryptocurrencies and tokenized assets
A well-diversified portfolio would therefore balance out each asset based on the risk profile of the investor. Equity-based assets and bonds are in any case expected to make up the bulk of the portfolio.
The equity portion of any portfolio should be diversified enough that it does not focus on any single sector alone. Investors should try to focus on sectors that are considered safe such as the energy sector and mining. Similarly, they can also invest in highly profitable sectors such as pharma and eCommerce sectors during the pandemic. Even in a single sector, the investment should be diversified among different high performing companies. So that if any single sector takes the hit, the investment does not all go down with that one sector.
Diversification is how investors protect against all-out losses. It is the first thing that an investor needs to learn. The portfolio must be diversified to reduce the risk of loss in case the markets crash. If 2020 has taught investors anything, it is the importance of diversification. In March when everything crashed, gold went on a boom followed by bitcoin. Oil crashed in February followed by the global markets, causing the investors to ditch everything else and pump money in the value of dollars. This is how investors jumped from one asset to another in 2020, to diversify.
When the stocks crashed the investors banked on bonds when bonds too crashed they banked on the dollar. When the market as a whole was down they banked on gold and bitcoin. Diversification is therefore how investors secure their investment.
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Initial Public Offering on the ASX
Fun Fact
What does a diverse portfolio look like?
Portfolios are diversified when they include investments in a variety of assets and aim to achieve the highest possible return while reducing the likelihood of adverse outcomes. A typical diversified portfolio will include stocks, fixed income, and commodities.
