Diversifying Your Portfolio ​

In the investing industry, it is an almost religious belief that in order to walk away with a profit with minimal risk, you must diversify your investment portfolio. The effectiveness of this technique may be debated. After all, the world's greatest investor prefers to put large portions of his eggs in one basket. However, for the common investor, it is a technique that does help mitigate risk and smooth out returns.

How do we use it? Let's go.

The 10 Big Sectors

Financials
Utilities https://www.google.com/url?sa=i&rct=j&q=&esrc=s&source=images&cd=&ved=0ahUKEwj1yqrlnr7XAhWFWCYKHXLvDdEQjhwIBQ&url=https%3A%2F%2Fwww.123rf.com%2Fphoto_21004978_set-of-simple-clean-and-modern-seo-services--web-designer-icons-suitable-for-wide-media-templates-li.html&psig=AOvVaw0r5JETdvew9ZHhsM5vFZN4&ust=1510754894523381​
Consumer Discretionary
Consumer Staples
Energy
Health Care
Industrials
Technology
Telecom
Materials
 
Having 10 sectors may seem overwhelming. How many should we choose when selecting stocks to invest in? Well we must look at the art of risk management, where your age and stage in your life affects the amount of risk you are most likely willing and able to take. If you are young, say a teenager to mid 30s, the amount of risk you can take is quite high, as you have less assets to lose as well as less responsibilities and most likely a stable income. However, the older you get, the more assets you gain, the more responsibilities you must attend to, and the less stable your income becomes as you approach retirement. Thus, a young investor may choose to only focus on 2 or 3 sectors, while a near retirement investor may select a wide range of stocks from all 10 sectors, in order to mitigate the risk to a large number of equities and reduce the volatility of their profits and losses.

Other Forms of Investment

A diversified portfolio does not necessarily have to contain all U.S equities. Many investors expand to other forms of investments, mainly:  U.S Bonds, International equities and bonds, Foreign Currencies, and Real Estate. International equities can be purchased through what is know as an ADR, which in simple terms is the U.S stock version of an international stock. Foreign Currencies can be bought and sold through brokers just like Stocks, popular brokers include: Oanda, FXCM and many more.  Real Estate does not always have to be purchased in its physical form, it is possible to invest in the real estate market  through REITS, which essentially are firms who invest your money in a basket of real estate properties for you, and pay out a large dividend. This means that you can invest in the Real Estate sector, without having to actually buy and manage property.

Hedging

Diversifying your portfolio is not the only way to mitigate risk in your investments, we can also use what is known as hedging. Hedging is essentially placing a trade that is inversely correlated to another open position, thus exposing less risk. Lets use an example. Let's say we have bought 100 shares of AAPL, however after a large move upward in the market, we feel as though the market is due for a pull back, and we, the smart investors, know that ¾ stocks have a correlation with the market (for this scenario, AAPL is listed on the NASDAQ, so the “market” is the NASDAQ), after all, the NASDAQ is only an index tracking the movement of the stocks listed under it. So, if we believe that the NASDAQ is about to decline, we can assume that our AAPL position is likely to decline as well. So how do we lessen our risk without actually selling any shares of AAPL? Well, we would buy a position in QID (UltraShort QQQ), an Electronically Traded Fund that is short the NASDAQ Index, thus QID moves UP when the NASDAQ moves DOWN, they are inversely correlated. By taking a position in QID, we lessen the potential loss taken on AAPL, as the money lost in our AAPL position is gained back on our QID position. This may all sound very confusing, but the basic principle can be summed up briefly: To mitigate risk, we take a position on an inversely correlated investment vehicle to our already open position. When one position goes up, the other goes down, balancing the gains and losses. However we do not always need to completely hedge our position, we can choose our Net Exposure. Our Net Exposure is the amount of risk still exposed after hedging a position. So if  60% of our capital is invested in AAPL, and 40% is in QID, then our Net Exposure is 20%.

Conclusion

Diversifying your portfolio is one of many ways to mitigate risk across your investments and should be used when passive investing; however, it is not the only risk management tool out there. We learned that there are a variety of different investment methods and vehicles at our disposal and should always take into account many different factors when managing our risk. ​