| Reduce risk without compromising returns.
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In our article Risk versus Return we highlight how every
investment has a risk attached. And how the higher the risk, the higher should
be the expected return from any investment. This probably then imply that if
you want to reduce the risk in your portfolio, the only choice for you is to
move your investments into low yielding investments. Right? Wrong.
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| Diversification across investments is another way to
reduce the risk of your portfolio.
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To understand how, look at this simple example (it involves
some basic statistical concepts but don’t get turned off, its simple to
understand and you can get into the calculations only if you want) -
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Say, there are two assets A and B. Both assets have a
potential return of 10% and a standard deviation (a statistical measure which
measures the variability (i.e. risk) of the potential returns) of 20%. Also,
the returns of both these assets are uncorrelated i.e. the performance of Asset
A is not dependent at all on the performance of Asset B.
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Now assume you invest equally in both these assets. Your
weighted potential return (0.5 * 10% + 0.5 * 10%) will equal 10% - this is the
same return as that for the individual assets. However, due to the fact that
you have now spread your risk over two uncorrelated assets, the standard
deviation (i.e. risk) of your portfolio will be 14.1% (lower than the 20% for
each individual asset). Refer to the supporting Statistical Analysis if you
want to understand how.
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It is important to understand what this means.
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You would have been able to reduce the risk profile of
you’re the returns on your portfolio to 14.1% (from 20% for an individual
asset) without having to compromise on your returns, merely by diversifying.
So, by choosing two assets whose returns are not correlated (this is important)
like say Stock A which is a pharmaceutical company and Stock B which is a
software company, you can reduce your risk while not necessarily having to
reduce your returns.
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In summary, there are two things that are important to keep
in mind while planning your investments -
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| 1. Every asset has a risk attached to it. |
And, the higher the risk, the higher should be its expected
returns.
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| 2. Don’t put all your eggs in one basket.
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By diversifying across assets, you can reduce your risk
without necessarily having to reduce your returns. You don’t have to get into
calculating standard deviation of the return of your assets, you need to just
be aware that if you diversify your portfolio, your overall portfolio risk will
be lower.
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To get the maximum benefit of reducing your risk through
diversification spread your portfolio across different assets whose returns are
not 100% correlated. Different assets should ideally span across different
asset classes such as fixed income, equity, real estate, gold as well as
different investment options within these asset classes e.g within equity
shares, your exposure should be to companies in different sectors; or within
fixed income investments, partly government risk and partly corporate risk.
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As a thumb rule, diversify your investments across 15-20
different individual assets.
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