Is diversification the only means investors mitigate risk?

Risk is something people don’t like to take because of the grave consequences it may pose. If people are not comfortable taking risk in their normal daily activities, then it even becomes more difficult when it is money or investment related. It is known in business cycles that Ghanaians are minimal risk takers compared to their Nigerian counterparts. The catch in this assertion is the prudent nature in which the Ghanaian investor throws his/her money into the market. In investment, it has been proven that there is a positive correlation between risk and return, hence the cliché “the higher the risk, the higher the return and vice versa.” Over the years different theories have been propounded on how to reduce risk in investment. The most popular one is diversification, which is the central focus of this article. This article seeks to enlighten readers on other ways of reducing risk in investment apart from diversification. This is not to underscore the need for diversification but to give readers a rather deeper, practical and thoughtful insight on risk reduction in investment. In finance, risk is basically variability in expected return, which is mostly negative. All investments come with associated risks. For instance if you invest a principal of GH¢ 100,000.00 and you expect to get a return of GH¢5,000, risk is the uncertainty that your expected return might not be realized (i.e. if you make a return lower than GH¢5,000).



Diversification is the most common method for reducing investment risk. Diversification is spreading your investments among several asset classes such as stocks, bonds and cash & cash equivalents (savings accounts, fixed deposits, recurring deposit) etc. This enables you to effectively reduce your exposure to the overall investment risk because different classes of asset respond to economic changes in different ways. For example, if stocks are down, then interest rates may be up, which means that bonds could be a good investment. Alternatively, if inflation is high, your returns from bonds and cash and cash equivalents go down in real term. However, businesses usually factor inflation in their prices and hence stocks do not change their returns very significantly on this account. For example, if you invest in four different sector funds such as technology, health care, utilities and financials, then your overall equity risk may be reduced because at least one of these sectors is may usually be performing well. This is because, assuming purchasing power reduces owing to high inflation for example, people may cut down on expenditures like technology which will affect the performance of that sector, but necessities like utilities and healthcare may still be accessed boosting incomes in those businesses. Achieving diversification is done through asset allocation. Why diversification is not enough?



Diversification does help reduce investment risk, but you must remember that the long term results of a diversified set of investments are far from certain. It is an established fact that over diversification neutralizes the gains on investment. There are some risks that are non diversifiable (Systematic risk): These are risks that are associated with the entire economy. This can be in the form of adverse macroeconomic changes such as unfavorable exchange rate (high depreciation), high inflation, sky rocketing interest rates and bearish stock market and so on.



OTHER METHODS OF REDUCING RISK IN INVESTMENT



So many factors contribute to the risk inherent in any investment; the investor’s ability to identify that risk would be a step to its mitigation. As indicated earlier, risk is the uncertainty of expected return, so if an investor can identify the reasons why he or she might not meet the expected target, an attempt to mitigate the impact would mean reducing risk. The under listed are some of the ways of mitigating risk investment. Hedging---- Hedging is a financial strategy used to reduce the risk of investing in financial markets. Like insurance, hedging can help avoid some losses, but it also may reduce some upside potential for returns on investment. An investor who believes he can make a profit on the increase in value of an investment will reduce potential losses by betting on the decline of a related investment. The method of reducing risk is mostly done by financial institution, big companies or government. An investor with a small amount of funds to invest may not benefit because he or she would be shedding off some gain in trying to reduce risk. Derivatives such as options and futures are used to hedge investments. Increase investment time horizon----One of the easiest ways to lower your equity investment risk is to simply give them time to grow. Investing for the long term would help you avoid short term fluctuations that can result in losses if the investor decides to sell his investment. Long-term investors are much more likely to see their investments grow over time than market timers who invest for the short term.



Match the investment horizon (time) and need of fund---Another means of reducing investment risk is matching the time and the required cash you need at that point in time. If you can forecast that you will need money or funds at the end of the fourth year, you don’t need to invest for just three years, for example. It would not be financially prudent to invest in equity for one year and expect to get a good return when the stock market is bearish. However, in a bullish market, some equities can gain more than 100% within a year. Nonetheless, the only advantage with regards to fixed income is that your principal is preserved. For instance if an investor will require funds in the say four year then an investment in mutual funds with a balanced proportion in stocks and bonds should be your choice.



In case you are investing towards the long term like five years and above, then equity or equity based mutual funds should be your choice of investment. It is always useful for an investor to know about investment products that would help him or her meet their investment objectives. HFC Investment Services Limited, which is the foremost investment management company to introduce collective investment schemes in Ghana, currently has four classes of collective investment schemes that cut across balance fund, money market fund, equity fund and real estate investment trust. Also, other investment banking firms have similar products that that can assist you to match your investment time horizon with your investment objective.



Research before taking investment decisions --I have always advocated against investing based on sentiments because the market does not operate on sentiments but on fundamental economic indicators. The onus lies on the investor to research to identify companies that for example, constantly pay dividends (for income investors) and mutual funds with good records of high gains to reduce the investment risk. For instance, if a listed company has a dividend payout ratio of 10%, it means that the company you have invested in will at the end of the year, pay 10% of its profits as dividends, and that guarantees that at least you have a certain inflow as dividends. This means whatever happens to the share price of the stock you will keep getting at least 10% just by dividends, as long as the company continues to make profits. If the price goes up, you get the benefit of capital gains as well. All this can be discovered through a rigorous research, or through the assistance of research departments of your investment advisers.



Research into corporate bond issuers---When you are investing in a fixed income instrument like bonds issued by private bodies especially, research thoroughly on the issuers of the bond in order to ascertain their ability to pay coupons and principals on time. Issuer risk refers to the risk that the issuer may for one reason or the other be unable to meet the coupon and principal obligations on due dates. To eliminate this risk, the investor must examine the nature of business of the issuer, its internal procedures and projections for the future, the institutions balance sheet and appropriate credit enhancement to ascertain its credit worthiness. In addition, the investor must find out if the issuer has set up a sinking fund for the bond issue with its bankers to assure you timely payments of your principal and coupon payments. You also have to find out how willing their trustees are in terms of closely monitoring of the sinking fund account to prevent shortage of funds towards repayment of interest and principal when they fall due.



Analyzing of term sheets to a Bond issue---One other area a bond investor must check is the term sheet. The term sheet spells out the date of issue, maturity date, interest and principal repayments, purpose of bond issue, transferability of bond, bond security (collateral) amongst others. If an investor investigates these areas by taking time to read the terms to ascertain whether or not the terms of the issue is favorable to him or her before investing in a particular corporate bond, it would be a major step to reducing exposure to certain risks in investment.



Choose only safe and guaranteed Investment---Every investor has his or her own investment objective and risk profile and this determines what an investor invests in. Investors should be very truthful to themselves by objectively identifying their risk profile and placing investments to meet it. Every investor has the option to avoid investment risk by choosing only safe, and guaranteed investments. Choosing to avoid investment risk is one of the smartest decisions you can make until you have learned the skills you will need to manage risk appropriately. This strategy has its own challenges because the investor may not get better returns because of ‘the higher risk, higher return’ principle. Once you avoid the risk, you may not get the juicy return you may be yearning for. Either ways, the investor takes the decision.



Take Only Calculated Investment Risks---Adopting the strategy of taking only calculated risk takes knowledge, research and common sense. To learn how to take calculated risks you have to understand how to view markets from a logical and rational perspective – not an emotional one. You also need to understand certain ratios and indicators you can use to help you assess the market.



One ratio some financial professionals use in an attempt to determine if the stock market is overvalued or undervalued is the price to earnings ratio, or P/E ratio. Another indicator of recessions is the yield curve. The process of making investment decisions based on a calculated form of risk taking is often referred to as tactical asset allocation.



The need for a professional advice----Every investment is done for the achievement of a future objective. There are a lot of people who have enough funds for investment but they do not have the expertise to do a thorough risk analysis before investing. Such investors need the services of investment bankers, investment lawyers and so on to help them professionally analyze their risk exposures and make recommendations towards reducing investment risk. In conclusion, risk would continue to exist as far as the world is imperfect and as far as expectation of returns exist. Every investor must take steps to safeguards their life savings in the form of investments by critically researching before investing. There is the dire need for an investor to scrutinize any bond indenture he or she lays hands on to determine whether the terms are favorable to him or her before investment is done. Reducing risk should be a conscious effort by the investor and should not be left to chance otherwise it is not worth investing. If the investor however feels he or she is not sophisticated enough to understand or examine his risk exposure, then there is a need for a professional advice at a little fee to help an investor to carefully examine his or her risk exposure. Diversification is good in reducing risk, but is not the ultimate in risk reduction because the above reasons attest to this fact. Investment is good as it helps secures your future but must be done tactfully by closing almost all loopholes that would expose your investment to avoidable losses.



Please direct all comments and suggestions to [email protected], © 2013, Sophia Kafui Teye, Blog: www.skafuiteye.blogspot.com.