When it comes to building your nest egg, the most important strategy is to minimize loss. The best way to minimize this risk is through the power of diversification. By diversifying your portfolio, you are ensuring that your nest egg is spread across different baskets. Diversification helps to strengthen and protect your portfolio.
Your chances are increased that if one area falls another area that you have invested in will remain strong, and your assets will be protected..
I define risk as the probability of things going wrong. Once things have gone wrong, they cannot go right. Older investors will remember this feeling they have after their losses, of wanting to turn the clock back. It is the same feeling you get after losing a loved one, when you want to reach out and touch the person after she or he is gone.
The preventive part is all about ‘diversification’, almost the only way to manage risk as defined in financial markets. Both risk measurement and diversification lend themselves to mathematical and statistical analysis, giving classical finance its biases. .
Value investors do the opposite. They add to their positions as a scrip goes down, playing to be the ‘last man standing’, i.e. trying to buy the last falling share as sellers depart the stock. The more of these ‘last’ shares they can pick up, the better their returns, provided of course, they have bought a safe, steady business at a great price, and the business recovers subsequently. .
In this strategy, you should try to trade a correlated pair as part of your diversification strategy. Like buying the market leader and short- selling the market laggard. A caution here is that if you are buying at the bottom of the cycle, then the laggards gain more than the market leaders. In a bull market, buying the market leader and short-selling the laggard may be a good trading strategy. Make sure that you don’t make a mistake in reading the market for example, is this a bull market or a bear?. Across the world, the cost of capital will soon start to drop. That would suggest a very shallow bear market, if we see one at all. Even a normally ‘bearish’ person like me is not willing to take a stand.
Statistically one thing is clear – traditional means of diversification won’t save you. Remember one common mistake: mindlessly diversifying into, say, 100-200 stocks, which then go unmonitored for entry and exit points. Since the investor no longer knows enough about these businesses, he is prone to fall prey to rumors. In effect, the act of ‘diversifying’ will actually increase the probability of losses rather than reduce it.
True diversification includes far more investment choices than just stocks and bonds. It includes other non-correlating asset classes that don’t intrinsically involve either speculation or timing. Aggressive investors like the readers of this article must be having more than 50 per cent of their net worth in equities, especially if they are below 40.
With each investment be sure to invest no more than you can afford to lose, so you can sleep at night. And use dollar cost averaging – taking a fixed proportion of your personal savings each month to add to your investment holdings, so that volatility becomes an advantage over a long time horizon. Only then will diversification begin to make statistical sense.