Published 09.08.2013 by

Tips on how to diversify your portfolio | How real fund managers manage Risk

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Here are some tips on how to diversify your portfolio. If picking the stock market were that easy, you would pick a stock, make a fortune out of it and retire by the age of 20. Fact is, the future is unwritten. We don’t know what the stock market will do tomorrow, or next week, or next month. As professional analysts, we will weigh up the probability of market performance based on our analysis, and then establish a Risk management approach to investing. We always cater for a “worst case scenario”, and that way our portfolio has the potential to outperform the markets even when they are falling.

To be successful in the markets, reality is that you need an edge, what we like to call a ‘proven strategy’, an action plan that you stick to, and a management plan for your investment capital. Investing can be simple, you just need to understand the reality, and not use the Hope and Pray method of investing.

So I’m going to go through a few of the essential portfolio management techniques you need to know when managing your own hard earned money. The tips on how to diversity your portfolio.

Don’t put all your eggs in the one basket

Manage Risk on your portfolio

It’s a simple one, but putting all your investment capital onto the one position is probably the biggest mistake we see on a constant basis. This mostly occurs with small amounts of capital. We refer to this as the Hope and Pray method of investing, because if the stock price doesn’t move favourably, more often than not, the investor will simply put it in the bottom drawer and forget about it.

For investors in this scenario, we recommend having a plan to keep building your investment base. Add small amounts of capital on a regular basis, and have a plan to buy/accumulate stock until you have some diversification amongst shares. Look for a cheap broker to facilitate the transactions as the cost can eat into your capital/profits.

Sector Diversification

This is an industry standard, that follows putting all your eggs in the one basket. When you are choosing stocks to invest in, selecting what type of stocks you buy is a key factor. Some sectors will perform better than other sectors during different cycles of the markets, and while it might be tempting to load up on various stocks that are performing, reality is that when that sector starts to decline, you are bound to be in for a bumpy ride.

You may need professional assistance in defining what sectors are performing and what sectors are underperforming. You will also need to work out how you are going to choose stocks within a sector. This could include choosing Growth stocks, Value stocks, Blue Chip stocks or Speculative stocks.

By diversifying into various sectors, you reduce your Risk that a negative market reaction in one or a small group of stocks will impact your portfolio.

Have a plan – know what to do

When things go bad, the average investor will put their head in the sand, block their ears, or usually retort with “the markets will bounce back”. While it’s true that the stock market is typically geared for a long-term upwards direction, those investors who try to ride through the market dips end up either selling at the bottom of the market after they have worn too much pain of loss, or start selling as the markets bounce, happy to have recovered some capital.

Knowing a simple fact such as “the markets will trend up, down or sideways”, and having an action plan on what to do in each scenario, provides you with a guideline to take action. How often have you heard someone say “I knew the stock would do that”, or “why didn’t I sell when I saw that top”?

Take the guess work out of your decision making process, and implement a tested and proven approach to investing. It’s what the professionals do! Oh, and ensure you act on your plan and not second guess what you think the markets might do. More often than not, you will get it wrong!

Hedge against a falling market

Majority of investors don’t know how the markets really work. All they see is that stock prices rise and fall. Many think there is some sort of conspiracy, especially against them, where the Market Makers are there to eat the ‘little man’ alive.

Nearly all major stock exchanges have a market called the “Derivatives Market”. Using Exchange Traded Options (ETOs), the investor can hedge their invested capital against a fall in the market. Much the same as you might buy insurance for your car! We call this a Hedging strategy – that is, to hedge against a fall in the market.

You can choose when to apply the hedge, and when not to implement. But if you are concerned that you may lose value in your portfolio, then the peace of mind you get from knowing you have some degree of protection can help you sleep at night.

Don’t be afraid to Sell

Investors are greedy. When a stock price has risen strongly, they keep holding onto the shares in the expectation that it will continue to gain strongly. When the stock price starts coming back, they have the view that it will recover. When it falls too much, they continue holding in the hope it might become breakeven. Eventually, they can wear the pain no more, and sell shares. Typically at the bottom of the movement. And murphy’s law is that the share price will rise immediately after you sell at a loss!

Our previous point about having a plan on what to do with your position will help with this point. Don’t be afraid to sell your stock, no matter if you are in a profit or a loss. In the modern stock market, prices are far more volatile and move relatively quickly. You need to take action and capitalize when prices shift, and not Hope and Pray for what you think the stock price might do.

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Matthew Brown – US Stocks & Options specialist
Client Advisor

Halifax Investment Services
ASIC Australian Financial Services License Number – 225973

Matthew is an Authorised Representative of Halifax Investment Services (Halifax). Halifax provides broker services, including Full Service and Discount Services using multiple trading platforms. For Discount platform services, Halifax charges the same fees for phone service as the online trading platform.

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