Managing Investment Risk Through Diversification
Return on Investment (Photo credit: LendingMemo)
I was just talking to someone earlier today about investing. He felt like there was really nothing that was a "good deal" right now and seemed content to sit in cash. A quick survey of the investment landscape would indicate that there is quite a bit of risk in investing in many asset classes, including stocks, bonds, real estate, precious metals, etc. However, even cash poses a risk due to inflation eroding the value of money. In particular, there are many observers of the stock market who are saying it has "topped out" or it's going to crash. The same can be said for other asset classes as well - bonds are too risky if interest rates rise/inflation comes and real estate values have increased dramatically since the Great Recession are other examples. The truth of the matter is a good investor can make money in any market environment through diversification.
As investors, we need to look at the array of assets that can be invested in and make sure we are broadly invested in a number of different asset classes. Wealthy investors stay diversified and also stay liquid to take advantage of new investment opportunities.
For example:
Stocks (including options) - 20%
Bonds - 20%
Cash - 20%
Real Estate - 20%
Alternatives (early stage companies, oil & gas partnerships, precious metals, etc.) - 20%
By following a broad diversification strategy, you don't have to worry about timing the market and potentially losing a significant portion of your net worth in a market downturn.
When making individual investments, risk management should also be a priority. The first order of business in risk management is in doing your homework. Don't rely completely on others. Make sure you thoroughly research new investments and consult with those you trust for their opinion. Also, make sure you have a plan for when you want to exit the investment (i.e., sell after 30% return, 100% return, or if it drops by more than 20%). Investing should be taking calculated risks, not gambling. If you are buying a new stock, review the company's financial statements - are they showing strong and steady growth in cash flow? If they pay a dividend, have they consistently increased it and does it look like they can sustain it? Does the company have a good management team?
Sometimes you know more than you think - for example, someone I know shops a lot at Costco and knows the product offering there very well. In late 2009, she wanted to buy some shares but instead her stock broker convinced her to buy Lowe's instead. Guess which stock did better during that timeframe?