Diversifying your Risk in the Stock Market

Diversifying your risk in the stock market

Investments in the stock markets usually give much higher returns than any other form of investments. But it is also associated with higher potential risk than any other type of investments. That is why you need to be prudent while investing in the stock market. If you follow some simple rules, you can minimize the risk and can still enjoy good return from the stock market.

1. Diversify your portfolio: As they say, do not put all your eggs in one basket! Spread your investment amounts across many different and diverse sectors (like banking, oil & gas, FMCG, Real Estate, IT etc.). It is not very wise to invest the entire amount in one particular sector, even if that sector is performing brilliantly at present. If you do so, you are at a higher risk if that particular sector gets a hit tomorrow. Invest higher amounts in the sector which are performing well today, but invest in others, too; specially to the sectors which have a rising potential in future. Your portfolio should not be too biased to one or two sectors.

2. Invest in Blue chips: Investing in branded, large blue chip companies is a relatively safer option than investing in little known penny stocks. Blue chip companies generally have a transparent and healthy audit book, past results to check, a brand name to trust. Pick up some blue chips which are performing well over past few years and invest in them medium to long term; you are almost assured to get good returns. Investing in penny stocks, on the other hand, some times can get you much higher returns than the blue chips. But it is not easy to identify those golden penny stocks. Unless you are a seasoned player in the stock market or have some “insider’s information”, investing in penny stocks can be quite risky; more often than not, it is a gamble.

3. Do not go by the “news” or rumors: It is your hard earned money, so invest it prudently. Do not jump on to invest in certain stock just because there is some news that that stock will sky rocket in near future. This is outright gambling. Try to get as much information about the stock as you can before investing in it. Look at the past performances, audit books of the previous years. Evaluate the prospect of the sector to which the stock belongs. See the P/E (Profit to Earning) ratio; it is not wise to buy a stock which is already selling at high premium. In short, invest your money judiciously.

4. Keep yourself up to date: Keep yourself up to date for any political or regional activities that might adversely affect the sector you are invested in. A new party in power after the general election or government policies on tax, import/export duties, central bank interest rates etc. can have huge impact on your investments. In today’s era of globalization, all markets in the world are interlinked. A big fall in European stock market can have negative impact on Asian stock markets and vice versa. So, you have to have brief knowledge of other major global markets as well. If you are well versed with the world affairs, then you are in a position to take the right decision at the right time to secure your investments.

5. Follow the big fund strategies: Try to follow the investment strategies of big and successful mutual funds. Look for the sectors and stocks they are investing heavily on and invest in those stocks. Also keep an eye at what they are selling off.

6. Set your Target: Another big dilemma in stock market is when to enter or exit. Ideally you should enter at the bottom most price and exit at the peak. But practically you will never find those bottom or peak. For entering, look at how much it has fallen from the highest level, look at the valuations. If you are waiting for an entering opportunity, then enter when the rate of fall has slowed down, the price has more or less stabilized and the valuations look attractive. Similarly, for exiting, first set some profit target. If the stock continues to grow beyond that then sell off when the rate of rise begins to slow down and the price stabilizes in a range.

7. Use stop loss, partial profit booking and averaging tactics to minimize the risk: In spite of taking all cautions, one or two of your stocks might generate loss. What should be your tactics then? First thing is not to panic. Just wait and watch. Things might be alright within a few weeks. But if there is a steep fall, or there is something adversely affecting the fundamentals of the stock, then set a stop loss target for you. This is a price up to which you are ready to sustain loss. If the price breaches your stop loss level, then sell it off. There will be some loss, but your entire investment in the stock will not be wiped away. There can be another situation of temporary fall; there is nothing wrong fundamentally with the stock, but there is a temporary fall. This might be a good opportunity to buy more of this stock at a lesser price now so that the average price of this stock will be less than your original price. This is called averaging out. For the stocks which are making high profits, you can make partial profit booking by selling a portion. This way, you get some real profit and some potential higher profit if the stock rises further.

Investments in stock market need to be as risky as some people say. By following some simple rules and investing prudently you can enjoy high returns from the stock market, without going for gambling.