For many people, stocks are the foundation of their investment portfolios, as they have the potential to bring impressive returns in a short period of time. However, if your investment portfolio is comprised solely of stocks, without any bonds or other cash equivalents, your investment portfolio is probably too risky.
A global financial crisis erupts when the value of financial assets in the global market drops rapidly. This can occur due to investor behavior or assets being overrated. When the global stock market crashes and the markets become extremely volatile, both businesses and consumers are affected. The interest rates increase, and banks become reluctant to allow consumers and companies borrow money, while charging higher interest rates on credit and loans.
Because of fear of not being able to afford their lifestyle in the future, consumers tighten their belts and spend less. As a result, companies are not making enough profit. This can force them to increase their service or product price, make employee cut backs or shut down some of their divisions. Thankfully, though, experts believe there is a way to protect your stock portfolio against the global financial crisis.
Stock Investment Risks
The two risks involved in investing are un-diversifiable risks and diversifiable risks. Un-diversifiable risks are caused by inflation rates, interest rates, natural disasters, war and other related factors. Any event occurring due to these factors will affect any company regardless of the industry. This is a risk investors can do nothing about. Conversely, diversifiable risk can be reduced by distributing investments between different financial assets. This type of risk is typically related to a particular market, industry, country, economy or company.
Diversification is Key
Diversification is simply a technique of reducing investment risk by investing in different industries and financial instruments. This is because different categories, industries and instruments react differently to the changes in the market. The same event may receive different responses from various investment categories.
Diversification does not necessarily mean you will not lose, but it can be used for long term financial objectives and for minimizing the risk. A diversified portfolio can tolerate the risks much more greatly than a portfolio that isn’t diversified. For example, if your portfolio bag is filled with minerals like gold and platinum and the mining unions decide to go on an indefinite strike like it usually happens in South Africa, the share prices of gold and platinum stocks will drop, as they would not be production for the duration of the strike. In addition, your portfolio value will also drop. However, if you invest in minerals, grain and other categories, only part of your stocks will be affected by the mining strike.
Diversification is important to reduce volatility and manage the risks. It is important to remember that you can only reduce the risks associated with stocks of an individual company or industry, but the risks of the general market are unavoidable. To create a risk tolerant portfolio, you have to master the art of asset mixing. You can do this by studying the market or seeking help from experts. Putting your stakes in different sectors or stocks is currently the only efficient protection against the global financial crisis. Diversification is not necessarily foolproof against stock meltdown impacts, but getting the correct diversification mix can greatly protect your investments.
This post was originally published on October 3, 2013 and updated on March 31, 2020.