Diversification
Diversification reduces the non-systematic risk of your investments. Since your positions does not move up and down in perfect synchrony, your diversified portfolio carry less risk than each of your constituent positions. In 1977 Elton and Gruber worked out an empirical example of the gains from diversification. Statistically 5 or 6 positions is a good number to have to balance the noise in the market, and to reduce risk. Anything beyond that is really not necessary, and doesn't affect the standard deviation of your returns substantially.
If you want to gain exposure to a larger market, instead of owning 10-20 positions, exchanged traded funds are the best way to gain exposure to numerous businesses with very few positions. The other downside of owning many positions is the commission fee from your broker; this can vary anywhere from $7-$25 per trade. The commission can become quite significant with shorter term trades and over longer time frames. If you are starting with a small amount of money ($1000-$5000) it is better to have 1-2 positions of an exchanged traded fund of your choice. Having multiple position is not always a good thing as it is hard to keep track of each of them. Diversify your portfolio, but keep the numbers manageable for you.
If you want to gain exposure to a larger market, instead of owning 10-20 positions, exchanged traded funds are the best way to gain exposure to numerous businesses with very few positions. The other downside of owning many positions is the commission fee from your broker; this can vary anywhere from $7-$25 per trade. The commission can become quite significant with shorter term trades and over longer time frames. If you are starting with a small amount of money ($1000-$5000) it is better to have 1-2 positions of an exchanged traded fund of your choice. Having multiple position is not always a good thing as it is hard to keep track of each of them. Diversify your portfolio, but keep the numbers manageable for you.
In short, diversification can help an investor manage risk and reduce the volatility of your security. However, even the most diversified portfolio is not free of risk. You can reduce risk by investing in different stocks by gaining exposure to as many sectors as possible or different asset classes like treasuries, commodities, and bonds. For example, the bond and equity markets move in opposite directions therefore if your portfolio is diversified across both areas, sharp movements in one will be offset by positive results of your other asset.The key is to find a balance between risk and return so that you are able to achieve your financial goal, but also can get a good night sleep.
Hedging and other ways to manage your risk
Another way to manage your risk is to hedge your positions. Hedging is an act of owning positions that will go up when your core bets go down. It is a means of protecting your positions and reducing the risk. A perfect hedge is when the two sides carry equal weight and your portfolio will stay the same forever (ignoring inflation). Now, I am not a big advocate of hedging. My argument is that instead of hedging your portfolio, why not just keep a portion of your portfolio in cash. This is a much better way to manage risk rather than having positions in your portfolio that work against you. Don't feel the need to invest 100% of your portfolio at any given time. Sometimes, it's better to keep a portion of your portfolio in cash and wait for better opportunities. You might spot a great trade, and you will be glad you have some cash in hand to use.
There are many ways and strategies to effectively hedge a portfolio, but personally the only type of hedging that I would consider is to allocate 1%-2% of your portfolio into put option contracts. This is the best way to hedge against market crashes in a bull market.
While your core positions may go down 10-30% in a crash, the value of your put options will go up 20 to 30 times. And if the market chug higher, you will only lose 100% of the value of your put options which is 1%-2% depending on how much you have allocated. Meanwhile, your core position will move higher and higher. |
Do your research about option contracts before you decide to use them, it is important to understand the risk that all leveraged products carry. It's very difficult to understand how options work when you are just starting off. If the market goes sideways, you can still lose 100% value of your put options as option contract have a time expiration. In short, hedging is like insurance; you are paying a portion of your money for a payout incase of a disaster. More often than not, the insurance money never comes back to you. Another good way to manage your risk to set a rule for yourself, and risk only a certain amount of your cash in each trade. 7% is quite common with most trades. The shorter the time frame, the lower this number should be. 5% for day trades, 15-25% for buy and hold are acceptable numbers. In the end, do what's comfortable for you, and make sure you are protecting yourself from most of the downside risk. Always use stop losses so that your portfolio is protected even when you are not around.