Don`t put all your eggs in one basket!

Don`t put your eggs in a single basket, cause a single rotten egg spoils the entire basket!

The world of investing also replicates a similar phenomenon. Guru`s in the investment world have always advised to invest in various asset classes to reduce the risk of eroding the portfolio value. This article explains the types of risks in a portfolio with an example of how you can reduce your portfolio risk to certain extent by diversifying your investment portfolio.

Components of risks in a portfolio...The total portfolio always comprises of two types of risks, which comprises of mainly two components:

The first one is the market risk comprising of interest rates, recessions and wars. Though classic guru`s have strongly propagated that this cannot be eliminated, experts in the investment world can apply special hedging strategies to reduce the currency, inflation, tax and regulatory risks. However, you cannot eliminate the risks associated with natural disasters.

The second is the unsystematic risk which is also called stock specific risk. To explain in simpler words, if a company launches a new product in the market and it is successful, the revenues of the company will increase leading to an increase in the share price; however, if the product fails, it is likely to be called back and the news is more likely to have negative impact on the company`s share price.

While systematic risk is cannot be reduced, unsystematic risk is the one which is reduced by diversifying your investments. We shall explain how.

To understand the disastrous effect of parking your investments in one basket, let`s take an example:

I have with me Rs 10,000 to invest in equities and I buy 200 shares of a speculative stock trading at a price of Rs 50. If the price of this stock falls by 50%, say to Rs 25, the value of the portfolio (suppose it contains only two stocks) will fall to Rs 5,000 (an equal proportion).

Let`s take another case, where I have the same amount that is Rs 10,000 which is partly parked in a speculative stock (200 shares @ Rs 25) while the remaining amount (50 shares @ Rs 100) is parked in a defensive company. Now suppose, the price of the speculative company falls 50% to Rs 12.50 and the price of the defensive company stays at Rs 100, the total fall in the portfolio value will be Rs 7,500 (12.50*200 + 50*100). You minimize your loss by Rs 2,500 by investing in two companies rather than 1.

Diversification, which simply means parking your investments in various investment instruments, surely helps in reducing portfolio risk!

However, the English idiom - No pain no gain applies to the world of investing as well. The higher the risks, the more are the returns. But the question is goes you want take?

Each person has a different risk bearing appetite. A young investor who still has long yours to live and earn surely is able to bear a lot of risk than a near retirement employee whose earning capacity is less than his predecessor. Thus, a there is always a trade-off which occurs between expected returns and the amount of risk you want to take.

If you are a high risk taker, you will definitely have greater proportion of your investments in equities. In such cases, your risks can be reduced by adding more stocks in your portfolio. How many stocks should you add? Academic studies have shown that as the number of stocks in a portfolio increases, the portfolio`s risk falls towards the level of market risk.

Conversely, a low risk taker will invest less proportion in equities and greater proportion in low risk bearing instruments like bonds, commodities and real estate’s investments (which is also called diversification of asset classes). Again, the proportion of each asset class in the portfolio will depend on the investor`s goal and his risk bearing appetite.

Ultimately, the decision lies in the hands of the investor on how he wants to choose his portfolio prudently in order to earn maximum returns with minimum amount of risk!