Making investment decisions can be a frustrating process. Two big factors make the process difficult. First, world markets are becoming more interconnected. Second, the sheer amount of data you can access is overwhelming. Use these tips to reduce investing risk and volatility.
You know you should do it
All of us have things in life we know we should do- but sometimes disregard. We all should diet, exercise, do things in moderations, etc. There’s a simple action that any investor can take to reduce risk and volatility. But many of us don’t-or won’t do it.
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We don’t diversify our portfolios.
Why don’t we? Maybe because it’s boring. If we diversify, the overall investment performance of the portfolio is less volatile. The roller coaster that is investment fluctuation is not quite as steep- up or down.
While we gain a less volatile portfolio, we lose some potential upside. You may have attended parties in the late 1990s and heard from people who were getting great rates of return from tech stocks. If those investors were not diversified, however, they took a big hit when tech stocks sharply declined.
Three risks minimized by diversification
This Wall Street Journal article explains 4 current risks in the markets. I’ll address three of them. Consider how a diversified portfolio can reduce these risks:
#1- A few tech stocks with big influence
When overall market gains are driven by just a few large stocks, that situation presents a risk to investors. The Journal provides an interesting example. The NASDAQ-100 index tracks the 100 largest nonfinancial companies on that exchange. More than half of the gains in the index are due to only two stocks: Amazon and Google.
If Amazon or Google report weaker than expected earnings, those results may drive down the entire NASDAQ-100 index. If you simply own one index of stocks, you’re subject to the fluctuations that impact that index. Your portfolio should contain stocks outside of those top 100 NASDAQ stocks.
#2- China currency devaluation
China is devaluing their currency. This has a big impact on US firms doing business in China. Many US companies feel that they need to be in China- it’s the second biggest economy in the world.
Here’s the challenge: Say you’re PepsiCo and you’re manufacturing and selling soda in China. You need to convert Chinese yaun (their currency) into US dollars. If the yaun is weaker, you get fewer US dollars when you convert. PepsiCo is losing money on the currency exchange- which hurts their profitability.
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To reduce this risk, own some US companies that have less exposure to the Chinese economy.
#3- Rising interest rates
The Federal Reserve has been considering raising interest rates for months. Speculation is growing that the Fed may raise rates before the end of the year. What’s the impact on your portfolio?
There’s an inverse relationship between bond prices and interest rates. If rates go up, bond prices will generally decline.
Now, this is an issue bond investors have not faced in decades. We’ve had generally falling interest rates for nearly 30 years. This means that bond prices have generally increased for 30 years as rates fell. That will change, when (at some point) the Fed raises interest rates.
Consider the percentage of your total portfolio that is invested in bonds. That portion of your portfolio will be affected (to some extent) by an increase in interest rates.
One more thing regarding bonds: If you own individual bonds and hold them until maturity, you’ll get the face value of the bond paid back to you at maturity. If you own $10,000 in IBM corporate bonds, for example, you get your $10,000 back in 10 years. Changes in bond prices and interest rates have no impact- unless you choose to sell the bond before maturity.
Diversification can help
Using a diversified portfolio doesn’t eliminate all of these risks, but it can reduce them. Consider reviewing your holdings for diversity- it can give you some peace of mind during market swings
Has diversifying worked for you? I’d love to hear from you.
Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies
(website and blog) http://www.accountingaccidentally.com/
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Terrapin Flyer, Wall Street (CC BY-SA 2.0)