Alhaji Kareem retired from the Federal Ministry of Works and was paid N28m in gratuity and ‘others’. Ecstatic and determined not to squander the funds, he decides to invest his funds in shares and calls his stockbroker to buy him shares in banks, FMCGs and oil and gas companies. Then all he has to do is wait for his investments to make good returns.
By 2009, his N24m investment in shares has been depleted to roughly about N16.2m. Bitter and angry, he shouts for his stockbroker to sell quickly so he can cut his losses and move on. He vows never to buy shares in life again and to instead invest in landed properties henceforth.
What he could have done differently to reduce the losses he incurred on his investment is Risk Diversification.
Today, we hear from our Corporate Finance Analyst, Adedolapo Adeniregun as she explains the nuances of Risk Diversification and how it can make investing less risky and more profitable overall.
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RISK DIVERSIFICATION: PERFORMANCE-BASED INVESTMENTS
Performance-based instruments refer to all securities/instruments which yield returns based on the price movement in the market. A good example is shares, since the dividends (returns) depends upon the performance of the company and what dividends the directors propose.
Essentially, the concept of Risk Diversification is that investing all your funds into a single financial instrument is risky because if that instrument were to perform poorly at a given time, all your funds would get depleted.
However, if you spread your funds across various financial instruments in various markets, it is unlikely that all the instruments will perform poorly at the same time. Simply put, an investor shouldn’t put all his eggs in one basket.
Diversifying your investment portfolio is simply spreading your funds across different financial instruments so as to spread the risk involved in investing in each instrument.
It is important to know that no matter how diversified your portfolio is, you can never completely eliminate risk, you can only reduce it considerably by diversification. Finance professionals all agree that risk can be minimized to an acceptable minimum. Picking investments with different rates of return ensure that large gains made in some will offset losses in other areas (if any).
Securities in your portfolio should vary by industry. Investing all your funds in stock in an industry that seems to be booming will put you in danger of a major loss if for any reason, stocks in that industry dip overnight.
(continued next week…)
