An idiots guide to investing on the stockmarket - part 4

 Risk

Okay, before I start, I'm going to tip "Northgate" and "Tullow Oil" as my two stocks to watch for the next few weeks. They are going places, especially Northgate. Its currently 23.8p but used to be £2.60...and now its recovering, and I've heard some positive inside info from people in the know.



Now onto the idiots guide to investing. As promised, I shall explain that wonderfully wispy concept of diversification of risk and why investing is a rich man's game. 

Basically its like this: You are a human and will always be fallible. Stocks can go up or down. You think a stock will go up...it might do, or it might go down. Every time we make an investment, we are increasing our exposure to the market, and thus also our risk of loss.

All this means that we need to take steps to reduce the risk of being wrong. How? Well there are a number of ways, but the simplest is "diversification of the portfolio". Basically this means buy a whole load of stock in various different sectors of the market, rather than just a single stock.



Okay lets understand that.

The stock-market is made up of many different smaller sectors where similar companies are listed, for example the Pharmaceutical sector lists companies likes GlaxoSmithKline, Astrazeneca and Shire, while the Oil lists BP, Heritage Oil, and Tullow Oil. 

Also, the entire market is cyclical in its ups-and-downs, as are the sectors...generally. But crucially, the ups-and-downs of the various sectors come at different times...So it makes sense to not buy, say, all three of Glaxo, Astra, and Shire, but rather only one of them, and one of the Oil companies. As at any one point you won't be exposed to the risk of the Pharmaceuticals or Oil sectors being wiped out.


In other words, chances are if one sector of the market is hit, another is doing well - so if you spread your bets across the board, you will strike lucky somewhere and perhaps lose somewhere too - but the net result is that you're still breaking even at least.

An example of this is the direct link between airline stocks and oil stocks. Airplane companies' main expenditure is on fuel - oil. So when oil prices rise, their expenditure increases and their stock prices fall. So in other words, when oil stocks rise, airplane stocks fall. So either you can buy one or the other and do REALLY well at one point and then REALLY bad at another, or you can do the sensible thing and buy both stocks, and do your buying and selling in the grey areas between the two peaks, meaning you take advantage of both extremes, but with less extreme profits, but also don't lose out in an extreme way.
  
The principle also implies that we shouldn't invest in only one company, as then we are leaving ourselves open to the vagaries of the market, but rather we should invest in at least 5+. We also shouldn't invest in one kind of stock (e.g. just miners) and also we shouldn't invest in just one area (e.g. just the British stock market) as well as diversifying in the risks of the stock we hold (e.g. buy some high risk stock and other more solid ones). And also, we should diversify in the types of investments we make - so buy things like foreign currencies, gold, silver, and bonds etc. (though I would recommend against buying bonds and other financial instruments which involve interest - as interest is morally unacceptable with the rich getting richer and the poor getting poorer, and Islamically it is forbidden.)
 
So to conclude diversify in:
1. numbers of stocks
2. sectors
3. geography
4. volatility of stocks (high risk/low risk)
5. kinds of financial instruments

My portfolio is currently diversified in the following way:

 


The results of that diversification check are fairly amusing actually, as I go on and on about how risky my stocks are...by in reality my actions show how risk-averse my investments are. Pharmas are a low risk sector, industrial transportation is a medium/high risk, oil and gas is a medium risk, and mining is high risk. But I'm adding another mining stock today...so I increase my exposure to volatility and lean my overall risk exposure more towards "high" again.



All this diversification theory (of which I've mentioned only a really basic version) leads onto the next-level crazy, wacky, shadowy world of hedging, and what hedge funds get up to. Next blog I'll be focusing on this rather tasty subject, after which we'll move onto the more placid and rarefied fields of share-price determinants.


But up till now, this is what the "idiots guide to investing" looks like:
1. basic introduction
2. choosing a stock
3. the weapons to understanding the market and some general advice
4. risk control (this post)

And finally, the diversification of risk is even mentioned in Shakespeare's "Merchant of Venice"!

My ventures are not in one bottom trusted,

Nor to one place; nor is my whole estate

Upon the fortune of this present year:

Therefore, my merchandise makes me not sad.

Lets hope our investing doesn't make us sad either!
The Merchant of Venice [DVD] [2004]