Portfolio diversification: a key to risk mitigation in investment

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Is there really something that has no risk embedded in it? Cannot the chair you are about sitting on break? How sure are you that you will finish the school are paying fees to? Is there any certainty about you not getting choked with the food you eat? Risk is one thing that cuts across our life, our inactions and actions. Almost everything we do has a level of risk associated to it.

Types of Risk

Risk in this case is the probability that the expected returns on an investment will differ from the actual returns. It’s a probability so uncertainty plays a role here. The following are the main categories of risk:

Systematic Risk

Systematic risk also known as non-diversifiable risk or market risk is that risk that affects the entire market. Not only is it unpredictable but also very difficult to avoid. For this reason, all investments suffer from it. Examples include inflation, political instability, natural disasters, economic recession, etc.

Unsystematic Risk

Unsystematic risk also known as diversifiable risk is that is specific to a company, an industry or a particular investment. It is predictable and occurs as a result of internal factors. It can therefore be mitigated by diversification.

What Is Diversification?

Diversification is a technique of spreading your funds among a number of different investment vehicles. Diversification basically means do not put all your eggs in one basket. This is straight to the point right? Worst case scenario, the basket falls and you break all your eggs. Just imagine dividing your eggs among a number of baskets been carried about different people. Even if one person falls, the eggs in the other baskets held by the other people will still be in good shape.

Diversification is one of the main ways of reducing risk. So the main aim of diversification is to reduce the risk associated with investing in only one investment vehicle. If there was no risk, there will be probably no need for diversification.

Important of Diversification

Reduce the risk and loss of your portfolio

One key thing diversification does is to reduce the losses that you will incur as an investor if you were to only invest in one financial asset. Diversification doesn’t remove the risk but it minimizes the risk. So when there is a reduction or loss from one asset, the other assets in the portfolio will help reduce the loss and its impact.

Enjoy Better Returns

Investing in more than one financial asset exposes you also to enjoy more returns based on the assets in your portfolio. You are likely to earn a higher return in the long term than someone that chooses to invest in only one asset class.

Downsides of Diversification

Complex in Nature

Diversifying a portfolio is not a straight away procedure and can be very daunting. It is with this that a number of investors prefer to resort to investment products that are already and/or partially diversified in nature.

Average Returns

It is true diversification is good for mitigating risk but an overly diversified portfolio can lead you achieving the average return on the market or the return similar to the return on the risk free asset. You must therefore be sure that you are not over diversifying your portfolio.

Additional Cost

There literally transactional cost in in investing in any financial asset so the more assets you invest in, the more cost you incur. You are likely to pay more for transactional cost due to your decision and action to diversify your investment.

What Should You Do

This is to help the lay investor so we will be talking about practical ways to understand and put this concept in to practice. It is first of all ideal that you don’t put all your eggs in one basket, the same way you must invest in different investment products and not only one product (financial asset).

Most people who don’t diversify their portfolio suffer huge losses when their investment is impacted. Just assume that all your funds were in an investment with DKM or Menzgold, you will most likely still be feeling the impact even up to now. But if you had divided the funds and invested it into either different companies or different financial assets with different companies, you will still have something left.

Financial asset is any security that can be bought and sold. Example is treasury bill, fixed deposits, certificate of deposits, stocks, bonds, hedges, collective investment schemes, bank deposits, etc.  The steps below is to make creating a diversified portfolio easy for anyone at all.

Determine your risk appetite

Know how much risk you are willing to take as it will determine what you should and should not invest in as well how much of diversification you need. Without knowing your risk profile, you will do something but it will not be the best.

List the financial assets you can invest in based on your risk appetite

After knowing your risk appetite, you should be able to or with the help of an investment advisor list the financial assets you can invest in. This is to help you know the options available to you and in creating the diversified portfolio.

Assess the past performance of your listed financial assets

Knowing the financial assets you can invest in based on your risk appetite is not enough. You must go a bit further to assess the financial assets based on their past performances considering other factors that influenced the performance. You don’t necessary need to an in-depth financial analysis as past performance is not a guarantee of future performance.

Determine what percentage of your funds goes where

Now that you know the financial assets and you have an assessment on it, you should divide your funds among the financial assets based the information you have about them and your risk profile. Keep in mind that the idea is to reduce your risk of loss while making some good return.

Disburse the funds to the financial assets based on the percentages

When you are done with everything, you must part ways with the money by moving it from you to invest into the financial assets you have in your portfolio.

Update your portfolio ones in a while

You must review and update your profile as and when you deem it necessary as the world and market keeps changing and new opportunities come.

>>>The author is an investment professional, a financial literacy advocate and a pastor. He is a CFA Level 1 Candidate and holds the Ghana Stock Exchange Securities Certificate. Email: [email protected]: Contact: 0241603589

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