Risks
are present in the stock markets. Just like how the markets can bring you
profit in a short period, it can also nose dive with the same speed. If
anyone tells you otherwise, don't believe them. In the heat of a bull market
(uninterrupted uptrend), you may not realise this. But the fact is, a sharp
correction or a long bear market may come sooner or later.
Diversification is the process of investing your money
into distinct sectors so that a risk that affects one sector does not
influence some other sector. Sometimes the fall is so sharp and wide ranging
that no amount of diversification helps. No guarantees here, but
diversification help reduce risks to an extent.
Risks:
There
are risks in the share market. Be aware of them. Risk basically means the
possibility of loosing value of a stock. You can loose money
in the stock market faster than any other investment vehicles. There are
risks like political, change of Govt. etc and there are also risks that
affect only a particular sector, for example due to budget proposals. Also, there are risks
in a specific business like change of a management.
Hence, think loud and clear about the risks before
deciding to go with the stock markets. One solace here is that, for the long
term investor, these risks do not possess as much a threat as a
short term investor.
Factors like interest rates, Investment decisions of the
FIIs (Foreign institutional investment), Govt. decisions affecting the stock
market, and even monsoon can play a role in these risks.
There are numerous factors like these. Even experts frequently fail to come
out with clear indications of upcoming issues affecting the markets. Hence
what is important is your understanding that stock market investments have
many risks and you must make right decisions such as what percentage of your
earnings can go into stocks markets etc.
Diversification:
As
previously explained, diversification is the process of investing your money
into distinct sectors. No
diversification means limiting all your investment to one single sector.
This
increases the risk since the shares you possess have no insulation
from risks because all your share holding fall into one single sector.
Risk in the stock market is not entirely taken out by means of
diversification. However risk gets reduced by diversifying your portfolio. In the broader investment arena, diversification means diversifying into
investment means
such as cash, stocks, and mutual funds etc. Real estate, and commodities may
be other examples.
Take the example of
these companies. Bajaj Auto, Maruti Udyog,
Mah & Mah, Tata Motors, Eicher Motor, Maha Scooter, and Hero Honda. All
these companies fall into the auto sector. If one were to buy only into these
companies, problem is that if there was a specific issue affecting auto
sector, bringing down the stocks sharply, it would devastate your
investment. Instead you
should be entering into sectors such as Information Technology, Energy,
Sugar, Cement, Banking, Infrastructure, and Engineering for example for the
purpose of diversification.
One thing I have
noticed in the May, June, and July 2006 period, when I have been working on this
document, diversification does not provide any help when there is sharp
fall across all sectors. That does not mean one should stop diversifying. It
does help however little it may be and of-course help during better times.
Ten to twelve
diversified stocks are said to provide optimal diversification. This means
that you should not buy shares of 100 companies operating in various sectors, which
effectively over diversify your portfolio and reduce the chances of making
better profits.
Next :
Brokers vs. Banks as Brokers
