Trading Rule – “Understand the need to diversify risk”

WHAT DO WE UNDERSTAND BY DIVERSIFYING OUR RISK? OBVIOUSLY, YOU CANNOT PUT ALL YOUR EGGS IN ONE BASKET. IF YOU ARE FULLY EXPOSED TO ONE OR TWO THEMES THEN ANY NEGATIVE MOVEMENT CAN MAKE A MESS OF YOUR PORTFOLIO. YOU NEED TO, THEREFORE, SPREAD ACROSS ASSET CLASSES AND FOCUS ON COMBINING ASSETS THAT ARE DIFFERENT. THIS WILL MEAN THAT YOU MAY SACRIFICE SOME RETURNS ON CERTAIN OCCASIONS BUT THAT IS A RISK WELL TAKEN. AFTER ALL, THE KEY TO INVESTING IS THAT YOU NEED TO PROTECT YOUR CAPITAL AND SURVIVE FOR THE LONG TERM…

WHAT DO WE UNDERSTAND BY DIVERSIFICATION?

As the name suggests, diversification is all about spreading your risk while investing. If you have a corpus of Rs.1 million and you invest all the money in banks, NBFCs and real estate stocks, then what is the risk you run? Obviously, your portfolio can get hit badly if the central bank decides to hike the interest rates. Higher rates will mean lower credit demand for banks and NBFCs and lower demand for properties. Here we are talking about 3 different sectors but the common link is the impact of interest rates. Hence diversification is not just about sectors but about themes. For example, when there is a global commodity down-cycle we have seen stocks from sectors as diverse as steel, aluminum, copper, nickel and crude oil; they all tend to get impacted. That is what you need to watch out!

DIVERSIFICATION: FOR TRADERS OR FOR INVESTORS…

This is an interesting debate! Most of us understand the importance of diversification in case of investors. When you are betting on a story you must ensure that you do not ignore the downside risk of your bet. Hence you need to spread your bets. But, what about traders! Interestingly, the concept of diversification is as relevant to traders as it is to investors. A trader assumes short-term positions and as a prudent measure, he needs to ensure that all his short-term positions are not concentrated on one story. For example, long on Hero Moto Futures, long on Rallis call and short on Tata Chemicals put is also not a great idea as the entire structure of trade is betting too much on a revival in rural demand. If that does not happen, then there could be losses on all three trades. Diversification is as critical for traders as it is for investors. In fact, for traders, it is all the more important as their primary focus is on the protection of their trading capital.

“The beauty of diversification in asset allocation is that it is as close to enjoying a free lunch as you can ever get” – Barry Ritholtz

6 GUIDELINES TO DIVERSIFY YOUR RISK IN MARKETS…

  1. Don’t add too many stocks that are similar in nature and performance. The whole idea of diversification is to add stocks and assets that are unrelated or enjoy a very low correlation. Adding more of similar kind of risk does not reduce your risk. On the contrary, it only substitutes your risk. The focus should be on negative correlation or low correlation among assets.
  2. Diversification benefits have to be evaluated over the long haul. Over the short term, diversification may appear to be an opportunity loss. At a time when the banking index is booming, adding more stocks that are unrelated may appear to be a bad choice as you may lose out on the froth. But the real benefit of diversification will only be obvious when the banking sector gets into a downturn. Over the longer term, diversification provides stability to your portfolio and thus indirectly enhances your risk-adjusted returns on the portfolio.
  3. Diversification needs to be constantly monitored. Here is why. There are times when correlations between asset classes are high and there are times when correlations are low. Adopting a one-size-fits-all strategy means that you are not making the best of shifts in correlation among asset classes.
  4. Diversification is meaningful up to a point only. Beyond that it just replaces your risk. While there are no hard and fast rules, it is estimated that a total of 12-13 stocks are sufficient to diversify your risk. A larger portfolio actually represents and also performs like a large representative index.
  5. Diversification is a trade-off in the larger interest of your portfolio. When you diversify your portfolio, you do lose some returns. For example, in asset allocation when you add debt to your equity portfolio, you tend to forsake some of your returns. But then it gives stability to your portfolio. Similarly, when you add liquid assets to your portfolio, you are again losing some returns, but then you are getting the benefit of liquidity. Diversification is not about returns, it is about risk.
  6. Diversification only helps you reduce your unsystematic or asset specific risk. In fact, diversification cannot help you with the systematic risk in your portfolio. For example, if the markets crash due to a sharp spike in oil then even a diversified portfolio is likely to get impacted. During the Lehman crash of 2008, we saw all kinds of assets including equities and debt giving negative returns. These are the kind of systematic risks that no amount of diversification will be able to reduce.

MORAL OF THE STORY; DIVERSIFICATION IS ESSENTIAL…

The great Warren Buffet once said that “Diversification is only for those who do not understand what they are investing in.” That is OK for a great investor like Warren Buffet to say but your focus should be on reducing your risk as much as possible. If you have to forsake returns in the process, that is part of the game. The world’s best traders and investors do tend to diversify their risk at some point. That is the core of investing.

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