UNDERSTANDING THE PORTFOLIO OF THE BASIC INVESTMENT
Husband exchanged Saturday dinner with his wife's family to watch the quiet football on Sunday. Children exchange TV shows for throwing garbage and washing dishes, because they need pocket money. Parents allow you to go home on Friday nights, if their children behave well throughout the week.
Trade-off in investment is a choice between risk and income. Getting a profit for your investment means taking a risk. At least to some degree. But what is the risk? And how much risk can you pay?
In this section, we'll look at the different types of investment-related risks, and show how to develop your own approach to risk taking.
Two Types of Risks are Common
First, there is the risk of losing money in the short term. Over the past 85 years, the American stock market of investment has generated an average of 10% per year. However, if you look closely at certain years, you can see that every fourth year is not profitable.
If we consider a shorter period of time - weeks or months - the results of financial investments can be even more volatile.
Investors tend to focus exclusively on this type of risk. Because it's so easy. Every day you hear on the radio and television about the behavior of the stock market. If you do not have enough of this information - you can check your stock prices more often, even online.
But do not let market volatility take over. If you allow me, you will completely ignore the second and perhaps far more important risk associated with the investment process: the risk that you can not achieve your financial goals.
How does obsession with market volatility hinder our financial goals? Maybe you will invest too conservatively. Volatility can also force you to decide on the sale or purchase of shares based on their recent short-term price dynamics, rather than how these purchases or sales enable you to achieve your financial goals. In short, due to market volatility, you may not see the forest behind the trees.
Always link the importance of achieving your financial goals to the magnitude of the risk of market volatility you can receive.
What Contributes to Market Volatility
The primary way to reduce daily and weekly market volatility is to diversify your portfolio by combining different types of securities into it. By incorporating multiple investment instruments into a single portfolio, you can reduce the impact of individual risk factors and thereby reduce short-term market volatility.
Market risk. Market risk arises when you invest in asset classes or in the economic sector. For example, - in US stocks or bonds of developing countries. Market risk is the risk that the entire market segment will lose its value. For example, US stocks may come down on price if investors decide that US stock markets have gone up too high for the current rate of economic growth. Alternatively, emerging-market bond markets might collapse if investors decide that high inflation is on the way, which will require higher interest rates and, as a result, lower bond prices.
To minimize market risk, it is necessary to diversify its assets, by allocating investment among different market sectors behaving differently under different economic conditions. Thus, you reduce your portfolio dependence on a single market segment. For example, high-quality US bonds usually feel good when investors are worried about the outlook for the global economy. That is why, US bonds can act as a good counterweight to stocks. Similarly, high-yield securities, such as shares in utility companies or real estate trusts, usually feel bad in the face of an increase in interest rates. This investment class should be offset by securities with low coupon income or without it at all.
Specific risks for the company. Operational and price risks are two sets of factors that affect the volatility of individual stock markets in the short run.
Operational risk is the risk associated with the company as a business, and covers everything that can affect the profitability of the company. Price risk is a risk that is more related to the company's stock price than its business. How expensive are stocks in relation to corporate earnings? For the cash flow? For the sale?
To limit the risks directly related to the company, the portfolio must include stocks instead of one company, but immediately the entire series of shares. A good way to achieve this is to include mutual funds, or ETF funds, in mutual fund portfolios, which are inherently diverse stock packages established by predetermined rules.
Country risks Whether you invest only in the US or place your funds outside their borders, you expose your portfolio to insurance risk. There is a political risk, or the risk that the current regime will turn out to be bad, there are economic risks, or the risk that the country's economic development conditions will be replaced by the worst, which will negatively impact the prospects for enterprise development. In addition, if you invest in securities in currencies other than US dollars (and usually when investing outside the US), there is a risk that foreign currency will lose some of your currency, and your investment will depreciate accordingly.
To eliminate risk in the country, you can do several things. If you invest in US and overseas markets - invest in the whole market, not just one or two. If you invest only in US stocks, make sure that the company you invest is not totally dependent on the state of the American economy. For example, make sure you include a portfolio of shares of such companies that participate successfully in global markets, even if they retain their US headquarters. Most likely, such companies will be more stable if the US economy slows down.
How Much Risk Can You Pay?
The impact of market volatility in the short term can be reduced by including stock portfolios, bonds and fund units, each of which will behave differently at different times. It's also worth remembering that planning the distribution of funds in your portfolio will allow you to prevent the greatest possible risk - a lack of money in your portfolio when you have to start withdrawing funds from it. You should be aware that in the ideal world of the planning horizon and your financial goals determine the level of risk you can afford.
But you are not an emotionless robot that can not react to market volatility. You are human and as a person, try to assess how market variability can prevent you from achieving your financial goals. Then try doing everything to eliminate the factors that are causing the increased risk. In other words, reduce your risk by allocating funds between different sets of markets, economic sectors and companies.
Finally, answer yourself the questions that will help you develop your investment philosophy in relation to market volatility and risk, and also to understanding the portfolio of the basic investment :
- What are the year-end losses on your financially and psychologically acceptable portfolio ?
- What kind of loss do you want to receive as a result of a five-year period ?
- How much risk do you want to take from your investment ?
- How do you plan to diversify various investment risks (market risk, corporate risk, country risk, etc.) ?
- Passing what tests of risk will enable the investment to get a place in your portfolio ?
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