Manage Risk in Stock Investing Through Diversification
We know stocks are a type of investment that can bring potential high returns and high risks. You can potentially double your assets in a short time, but they may also decrease dramatically.
What can you do to manage this risk? The answer is diversification.
"Diversify risk" refers to reducing unsystematic risk in your investments, which is the risk specific to individual stocks. This risk can occur due to various factors such as poor company earnings or negative news in the industry.
As long as your investments are well-diversified, a fall in a single stock shouldn't change the whole picture that much.
Systematic risk is caused by political, economic, and social factors and cannot be avoided by diversifying your investments.
So, how can you diversify your investments? Choose stocks that have a low correlation to each other.
This way when one stock falls, other stocks are less likely to follow the downtrend. There are three ways to achieve this diversification:
The first way is to invest across different markets.
For example. You could invest in US stocks, HK stocks, and JP stocks at the same time. Sometimes, these markets don't share the same trend.
In 2021, HK stocks declined while US stocks generally went up. Those who have invested in both US and Hong Kong stocks may not see a significant return, but they have diversified their risk.
The second way is to invest across different industries.
You may invest in both traditional and emerging industries, or both cyclical and non-cyclical industries.
Funds often flow between these industries.
When traditional industries go down, emerging industries may go up due to fund inflows.
When cyclical industries decline, non-cyclical industries may attract more funds and have the chance to rise.
In 2022, energy stocks in the US soared, while tech stocks dived.
Holding stocks of various industries with a low correlation to each other reduces the overall risk.
Your third option is to look at index ETFs.
To make your stock portfolio fully diversified, you may need to hold stocks in different industries.
An index ETF buys all constituent stocks of the index it tracks and thus can help investors achieve diversification in a rather simple way.
As a result, this type of ETF appears attractive to some investors.
However, index ETFs may have tracking errors and don't necessarily replicate the performance of the indexes they track.
Moreover, such ETFs can only generate limited returns since it's hard for them to outperform the relevant indexes.
To conclude, in stock investing, high returns come with high risks.
Consider diversifying your investments— you can invest in different markets, invest in various industries, or use the diversification brought by index ETFs to reduce unsystematic risk.
This presentation is for informational and educational use only and is not a recommendation or endorsement of any particular investment or investment strategy. Investment information provided in this content is general in nature, strictly for illustrative purposes, and may not be appropriate for all investors. Read more
