Risks & Need of Diversification.

Risks & Need of Diversification.

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.