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Decreasing Investment Risk: Optimizing Diversification

Investment risk diversification

An investor’s tool box doesn’t include a whole lot of options when it comes to decreasing investment risk. In general, the less risk one takes, the less the return that can be expected. While cash and investment grade bonds don’t expose one to a huge amount of risk, annual rate of return will be low — especially in the secular low rate environment we’ve experienced for many years. In many cases, investors that might have previously allocated mostly to bonds and cash-like instruments, are finding themselves gravitating to equity-income.

Investment risk diversification

Reducing Investment Risk With Put Options

Stock investors can protect their equity holdings by purchasing options products. A “put option” is akin to an investor insurance contract, where they can specify a predetermined data and price where they are allowed to sell a security thus reducing investment risk.

However, an option is not free. A premium must be paid to another investor who is willing to sell the insurance with the specified parameters. Contract price relative to current market price, the amount of time involved in the deal, and volatility of the particular security in question all factor into the put premium.

If the stock rises past the “strike” price of the contract, the investor loses only the amount paid for the premium. If the stock falls precipitously during the life of the contract, the investor can exercise the option to sell at a much higher price, effectively creating a profit relative to the investor that continues to hold the security with no protection.

For income investors, however, a long-term investment attitude alongside their passive cash flow desire generally precludes participation in the options market.

The Free Option – Diversification

Diversification, or spreading investment risk amongst many portfolio holdings, is probably the best “free” management tool available. The theory maintains that the more investments you own, the more insulated you are from general market risk. If you only own 2 stocks with equal allocation, and one of them goes bankrupt – you lose 50% of your money. However, if you own 10 stocks with equal allocation and one goes belly up, you’ll lose only 10% of your money.

On the flip side, if you own only 2 stocks and one of them doubles in one year, your overall portfolio will perform better than the portfolio where the same doubling stock is part of a 20 position portfolio.

Index Funds = Instant Gratification

Index funds are usually considered the ultimate source of “instant diversification.” By investing in something like the Vanguard 500 Index Fund (NYSEARCA:VOO) of large cap stocks, the investor is saying they wish to do no worse, nor no better, than the market. Investment risk is right away spread amongst 500 different companies.

The more performance inclined investor may decide they wish to try to the outperform the market, and own a smaller set of stocks, maybe 25 or even only 20. In general, the smaller the number of stocks you own, the more chance you give yourself to outperform. Although, looking at the glass half-empty, it may enhance your chance of underperforming as well.

What is Your Personal Risk Tolerance

The types of stocks you own may also foretell your performance destiny. If you own a portfolio of 20 biotech stocks that are burning cash, you are taking much more risk than someone that owns 50 blue-chip stocks paying dividends. You may, in fact, be taking more risk than someone who owns only 5 blue-chip type stocks.

Personal risk tolerance should also figure into all of this. It would be far more appropriate for a 35-year old professional with a good salary to be investing in the 20 position biotech portfolio, as opposed to a 75-year old retiree on a more fixed income. Although at the end of the day, I’m not sure anyone should have a 20 position biotech portfolio as their sole investment program.

There is no functional blueprint for how many securities one should own. Conceivably, a couple of stock indexes provides all the diversification that the average total return minded investor may need. More sophisticated investors will probably own a portfolio of individual holdings more levered to specific goals for their money. At the end of the day if a custom crafted portfolio fails to beat an index, one must question if the custom crafted portfolio was worth the bother.

Identify, Evaluate, and Managing the Risk

If there is a downside to indexing, it is that you will have to own the good, the bad, and the ugly of the market, whereas if you custom create a portfolio, you have more artistic license and ability to avoid the bad and the ugly.

Personal security picking skill and maybe a bit of luck will ultimately determine performance. Some investors may even be somewhat agnostic to equity return and more interested in creating a durable income stream. Either way, identifying, evaluating, and managing the risks that you take is a larger hurdle than most investors seem to realize. An ounce or two of risk mitigation could ultimately lead to many pounds of investment cure.

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    All trading carries risk. Views expressed are those of the writers only. Past performance is no guarantee of future results. The opinions expressed in this Site do not constitute investment advice and independent financial advice should be sought where appropriate. This website is free for you to use but we may receive commission from the companies we feature on this site.
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    Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.

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