Understanding three key fundamental investment concepts vital to being a successful investor.
Risk management
Diversification
Diversification is a strategy that involves investing in different types of assets or sectors to reduce the overall risk of a portfolio. By spreading the investments across various categories, the investor can lower the exposure to any single source of volatility or loss. Diversification can also enhance the expected return of a portfolio by capturing the gains from different market segments or regions.
It is based on the principle that not all assets or sectors move in the same direction or at the same rate, so a diversified portfolio can benefit from the positive performance of some while offsetting the negative performance of others.
Hedging
Investors often use the hedging strategy to minimize the risk of losing money in the financial markets. Just like in the physical world, hedges serve as a way of minimizing/protecting against negative outcomes. In a financial sense, a hedge protects a portfolio from taking on too many losses in the event of a downturn in any specific investment.
This involves taking a position in an asset or derivative that is opposite or correlated to the main investment.
The most common use of a hedge is in a 60/40 portfolio with a combination of 60% shares and 40% bonds. The reason it works is that when there is fear in the market because of economic concerns, people manage their money by transferring it to safer investments, so a lot of people might transfer their funds from stocks (higher risk) to Bonds (less risk) so when the price of stocks go down the price of Bonds go up.
By doing so, any losses incurred in stocks can be offset by the bond hedge, thereby reducing the overall risk. Hedging also protects against market risks such as volatility, inflation, and currency fluctuations. However, it is important to note that hedging does not guarantee profits but helps manage risks and minimize potential losses.
Trade Size
Finding the right trade size is crucial and depends on the diversification parameters of your investment portfolio. A smaller trade size lowers the overall risk to your portfolio, but it also reduces the profit potential. It's important to balance not risking too much capital on a single investment and still making a worthwhile return if it succeeds.
How to manage your idle money
There is an old adage "Time in the market. is better than timing the market". By allowing your investments more time to grow in the stock market, you don't need to time the market to be successful.
The average return in the 500 largest companies in the USA over the last 100 years is 12% annually, so the equivalent could be said that any cash you hold waiting for the perfect investment is, in fact, sacrificing the opportunity cost of 12% per year on average. So, minimize the amount of time your money spends outside of the market to a bare minimum.
Price Drivers
Understanding the underlying causes of price drivers can determine our success as investors.
Examples of price drivers could include:
fear in the market
profit margins
economic trends
investment fundamentals
In the market cause-effect relationship, price movement is the resulting output from an underlying cause or driver.
Summary
Be smart with your money by never letting it sit around. If it's not working for you, then you are losing out on much of the returns you could be making. If you are going to be actively investing, understand the price drivers for the investments you make, and always maintain risk protection.
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