Worried about making the wrong investment? Try diversifying
HOW TO MITIGATE RISKS AND THE POSSIBILITY OF MAKING A LOSS
You may have heard of the term FOMO (Fear Of Missing Out) being tossed around - just ask your friends who are in their 20s or 30s and you will know what we mean.
But above the FOMO mentality, there is another that sticks out like a sore thumb: The fear of making the wrong decision in investing. It is understandable that some of us may have an innate fear of making a less than ideal investment decision – no one wants to lose money. In fact, sometimes we rather choose to not invest at all than to make a decision that may result in a loss.
3-STEP MANTRA IN MITIGATING RISKS
While it is true that all investments come with an element of risk and the possibility of making a loss, there are proven ways to mitigate such risks.
The first step is to understand yourself. You can start by learning more about your personal risk appetite and clearly identifying your goals before you start investing.
The second step is to enhance yourself. This refers to your financial knowledge in the investments that you want to make. As the saying goes, knowledge is power. By grasping what you are investing in, you minimize the likelihood of making the wrong decision.
The third step is to mitigate your risks. Diversification is one way to manage your investment risk without necessarily holding back your potential investment returns.
HOW DOES DIVERSIFICATION REDUCE RISK?
Here’s the gist of how diversification works: Diversification is all about spreading your investments across many different baskets. By placing your capital in different investments, it reduces the likelihood of your investment from being wiped out.
An event that affects one basket is likely to have a small or opposite effect on the other baskets. For example, when an undesirable event affects the stock market, your other investments (e.g. bond) may be moving in the opposite direction, hence minimising or negating the overall impact to your investment portfolio.
HOW CAN YOU DIVERSIFY?
The more diversified your portfolio is, the more protected your investments will be against business and financial risks.
But how do you diversify your investments? There are three ways: Diversification through asset class, geographical location or industry, and investment style. All of which can be achieved through ETFs and unit trusts.
DIVERSIFICATION BY ASSET CLASS
Diversification through asset class is the most common. This is done through investing in uncorrelated assets. For example, a well-diversified portfolio consists of a balanced allocation of investments in equities, bonds, commodities, property and cash.
DIVERSIFICATION BY COUNTRY AND INDUSTRY
Among each type of asset classes, there are investments that will span across different geographic location and sector. This is best explained with equities where each company has its own geographic area of operation and its own industry (e.g. Technology, healthcare, consumer staples). Diversification can be achieved by spreading investments in different country and industry to minimize the impact of country or industry specific events.
DIVERSIFICATION BY INVESTMENT STYLE
Apart from country and industry, diversification can also be achieved through investment style. Stocks can be classified into different categories based on market capitalisation (small, mid and large cap) and style (growth, income and value). There are nine categories in total, from small cap growth stocks to large cap value stocks. For example, Amazon is a large cap growth stock. A good mix of stocks with different market capitalisation and style will help you to create a portfolio that may be more resistant to economic shocks. With the right diversification through different investment instruments, you can reap the rewards of investing and still maintain a low exposure to risk.
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