Risk & Diversification
Investing offers a great opportunity to increase wealth, but it's not without risk. The wrong trade can destroy wealth just as easily as it creates it, and it's important to talk about how to manage the risks of your portfolio as a whole.
This is especially important as you near retirement (or if you happen to be helping your parents with investing prior to their retirement).
That's what this post is about: minimizing risk.
Knowledge
The best approach that you can take to reduce the risk of a portfolio is through careful study. Detailed analysis of the investments in your portfolio, filtered down to the few that have the greatest likelihood of success will allow you to reap outsized gains while directly minimizing risk.
When I say outsized gains, I mean the sort of life-changing gains that can only be had through making very directed, pointy bets with high conviction. Fortunes are created through focus. $1,000 invested in Microsoft at IPO would be worth $2.9m today (plus $30k/year in dividends!)
You may be thinking that this practice is entirely depending on 'luck' or would otheriwse require 'fortune-telling' — or that you can only discover such companies in retrospect. Well, you'd be surprised. A bit of research goes a really long way (especially of the creative variety that you can't Google)1
The challenge, of course, is that this requires time, effort and domain expertise — something which many of us may not be in a position to offer. (If you'd like to know more about how to perform due diligence on investment opportunities, I'll be sharing a post on the topic in the future).
Diversification
If you simply don't have the time to spare, or the interest, to analyze opportunities thoroughly — then there's a 'hack' that you can employ: diversification. Instead of making a few large bets, you literally bet on the entire market. 2
The upside of this approach is that you are guaranteed to pick the winners! The downside, as you may have guessed, is that you're guaranteed to pick some losers too.
The net result is that buying the market gives you immediate protection from the risk of any single company taking down your entire portfolio — while also limiting your upside significantly.
It's possible to realize a 1000% return on a single stock, but that's impossible to do when you're diversified across a large group of stocks.3
To learn more about investing across an entire market, read the halal equity ETFs post.
- Sometimes you can find information that others won't have access to (and without violating insider trading rules). Example: Someone called up hotels in the middle of the COVID-19 pandemic asking about occupancy. Found out that they were doing really well, despite the stock being down 68%!↩
- ETFs allow you to do exactly this. Buy a single share of the SPY ETF and you'll get access to all 500 companies in the S&P500. You won't get HUGE gains, but you won't get wiped out if a few of the companies dip. You get a sort of OK outcome, that, in the case of the SP500 works out to roughly 7%/year in gains (net inflation) in a typical year. Not bad, but also not great. OK.↩
- It’s insane to steal money from one’s best investment to fund a second, third, fourth, fifth, and sixth best. It makes beating the market far more difficult than it could be, and it’s a confession that you don’t actually understand the investments you’re making. Source↩