Portfolio as far as equity markets are concerned can be compared with the game of snake and ladder. In case of snake and ladder game in order to reach the target one has to tackle many snakes because if snake bites you go down and also there are many ladders which give opportunity to go to target quickly, in the same way in case of portfolio there are many snakes in the form of various threats like stock market crash, economy meltdown and also there are many ladders in the form of stocks rising quickly due to great results or news or finding the value stocks in market meltdown and so on. As far as the investor is concerned he or she has to avoid the snakes and look out for ladders in order to reach the target return. In case of portfolio, the primary emphasis is to earn good return with minimum risk, let’s look at ways to reduce risk in portfolio –
- First and foremost way to reduce risk in the portfolio is to diversify the portfolio because if an individual has made a portfolio of only 1 or 2 stock then it is risky as the whole portfolio is dependent on 1 or 2 stocks. However if the individual has the diversified portfolio consisting of 10 to 15 stocks representing many industries then the risk of one industry performing badly is covered by good performance in other industry. So for example, if an investor has purchased only IT stock in his or her portfolio than his or her risk is greater as compared to that investor who has few IT stock, few Pharmaceutical stock, few banking stocks and so on.
- Another way to reduce risk is to have fixed target return because in the case of equity markets the majority of investors becomes greedy and make a loss due to not selling stock at the right time. So for example, if target return from the particular stock is 20 percent then one should sell the stock if stock gives that return and should not become greedy that it will give 50 percent return because greed has no limit.
- One should also learn to accept losses by keeping proper stop loss because majority of people due to their ego do not want to take the losses and keep sitting on losses for very long period of time which in turn leads to low return on overall portfolio as cash is stuck in the loss-making stock which could have been deployed in some other profitable opportunity.
- Another way to reduce the risk of the portfolio is to buy put options, put options give the buyer right to sell the underlying asset at a predetermined price no matter what the current price is. Hence, if an investor has a portfolio of $100000 then he or she can limit the downside by buying index put option because when the index falls the portfolio value will also fall but the value of put will rise thereby compensating the partial loss of the investor.
- Another way to reduce the risk is to learn proper cash management because the majority of individuals, as well as fund managers, do this mistake of investing all their cash in buying stocks when market are performing well and are at a high and when the market falls they do not have any cash. When the market falls cash is the king and sometimes it is better to keep cash rather than to invest in the markets as it is very difficult to predict bottom in falling markets.
As one can see from the above that portfolio risk to a great extent can be reduced by the investor if he or she keeps above points in mind and also the difference in case of snake and ladder game and portfolio is that in case of snake and ladder game all things are dependent on chance whereas in case of portfolio chance plays only a small part.