While investing in the stock market, amateur investors tend to invest in the shares of selected few, well-known industries such as gold, oil, etc. and deem their investment “safe”. This mostly work because prices of these stocks usually go up. The problem with so called safe investing is that it is not diversified. There is no risk mitigation and hence, you lose large amount of money if these investments don’t pay out. Investing in non-related stocks can seem risky but in reality, you stand to lose more if you don’t hedge your investments.
Building a diversified portfolio is very important for any investor. A portfolio is simply a collection of different shares or securities. While building a portfolio, one need to keep in mind that diversification is a good thing. It might not give as much return, but it ensures that your risk is mitigated and at least a part of your investment is safe. An age old saying goes, ‘never put all your eggs in one basket’. This applies to your investment as well.
Some industries have a unique relation with each other. When the share prices of one industry goes up, the share of the other industry goes up as well, for example oil prices and industrial machinery stock prices. Such a trend is known as positive correlation. The opposite of this is negative correlation where the stock prices move in the opposite direction. By ensuring that both of the positively and negatively correlated stocks are there in his or her portfolio, an investor ensures that not all his investments go bad if a slump occurs. This gives the investor varied sources of return and ensures that he/she is not vulnerable to lose everything.
In a study co-authored by Yakov Bart, an associate professor of marketing at Northeastern University, it was found that, “The fundamental way for any investor to minimise risk is to diversify, to invest into uncorrelated assets, which is basically the way to hedge your bets in order to minimise potential losses. Amateur investors would be better off picking stocks at random because that would reduce the likelihood that whatever you pick is going to be positively correlated with each other.”