Unpredictable Market
However, there will undoubtedly be some nasty air pockets which will leave us feeling distinctly queasy. An investor who can, at the very least, take his foot off the pedal when markets are turning down and increase his exposure when they rise again, will be much more successful in the long run. So how to spot when the market is coming to the end of a bullish or bearish phase is the real issue to address.
Risk- Return analysis
'Don't put all your eggs in one basket' is a well-known proverb, which summarizes the message that there are benefits from diversification. If you carry your breakable items in several baskets there is a chance that one will be dropped, but you are unlikely to drop all your baskets on the same trip. Similarly, if you invest all your wealth in the shares of one company, there is a chance that the company will go bust and you will lose all your money. Since it is unlikely that all companies will go bust at the same time, a portfolio of shares in several companies is less risky.
This diversified portfolio will clearly be preferred to either asset alone by risk-averse investors. The risk-neutral investor is indifferent but the risk-lover may prefer not to diversify. This is because, by picking one security alone, the risk-lover still has a chance of getting a higher return and the extra risk gives positive pleasure.
Risk-averse investors will choose the diversified portfolio managed by a proficient stock broker, which gives them the lowest risk for a given expected rate of return, or the highest expected return for a given level of risk .Diversification does not always reduce the riskiness of a portfolio. Certain types of risks such as political risks etc can not be mitigated in its entirety.
Diversifiable and non-diversifiable risk
Not all risks can be eliminated by diversification. The specific risk associated with any one company can be diversified away by holding shares of many companies. But even if you held shares in every available traded company, you would still have some risk, because the stock market as a whole tends to move up and down over time. Hence, this market risk is non-diversifiable, whereas specific risk is diversifiable through risk-pooling.
Unit Trusts and Mutual funds
Many small investors do not have enough wealth to invest in company shares to gain the benefits of a diversified portfolio. Yet the average return on investing in shares is higher than that on safe assets, such as government bonds or bank and building society deposits. Hence there is a role for institutions that sell small investors a share in a much bigger and more diversified portfolio.
Such institutions are generally known as mutual funds. They are like clubs in which savers pool their funds and then jointly own a diversified set of investments. These are sometimes known as unit trusts and investment trusts.
Mutual Funds play an important role in helping small investors to achieve international diversification. Just as diversification across companies is beneficial in improving the risk-return trade-off, so international diversification improves it still further. Small investors find it difficult and costly to buy and sell foreign shares, but mutual funds are able to access foreign markets and spread the costs over large numbers of investors. Investment opportunities for small investors are thereby greatly enhanced.
Markets are inherently unpredictable and even experienced investors have difficulty
in spotting the best times to be in or out. Even the best investors have endured periods when they have got it wrong. Because of this, investors should not worry too much about the short-term ups and downs of markets. Over time, markets have tended to rise because they reflect the growing wealth of the world and it would be surprising if this were not to continue
However, there will undoubtedly be some nasty air pockets which will leave us feeling distinctly queasy. An investor who can, at the very least, take his foot off the pedal when markets are turning down and increase his exposure when they rise again, will be much more successful in the long run. So how to spot when the market is coming to the end of a bullish or bearish phase is the real issue to address.Risk- Return analysis
'Don't put all your eggs in one basket' is a well-known proverb, which summarizes the message that there are benefits from diversification. If you carry your breakable items in several baskets there is a chance that one will be dropped, but you are unlikely to drop all your baskets on the same trip. Similarly, if you invest all your wealth in the shares of one company, there is a chance that the company will go bust and you will lose all your money. Since it is unlikely that all companies will go bust at the same time, a portfolio of shares in several companies is less risky.
This diversified portfolio will clearly be preferred to either asset alone by risk-averse investors. The risk-neutral investor is indifferent but the risk-lover may prefer not to diversify. This is because, by picking one security alone, the risk-lover still has a chance of getting a higher return and the extra risk gives positive pleasure.
Risk-averse investors will choose the diversified portfolio managed by a proficient stock broker, which gives them the lowest risk for a given expected rate of return, or the highest expected return for a given level of risk .Diversification does not always reduce the riskiness of a portfolio. Certain types of risks such as political risks etc can not be mitigated in its entirety.
Diversifiable and non-diversifiable risk
Not all risks can be eliminated by diversification. The specific risk associated with any one company can be diversified away by holding shares of many companies. But even if you held shares in every available traded company, you would still have some risk, because the stock market as a whole tends to move up and down over time. Hence, this market risk is non-diversifiable, whereas specific risk is diversifiable through risk-pooling.
Unit Trusts and Mutual funds
Many small investors do not have enough wealth to invest in company shares to gain the benefits of a diversified portfolio. Yet the average return on investing in shares is higher than that on safe assets, such as government bonds or bank and building society deposits. Hence there is a role for institutions that sell small investors a share in a much bigger and more diversified portfolio.
Such institutions are generally known as mutual funds. They are like clubs in which savers pool their funds and then jointly own a diversified set of investments. These are sometimes known as unit trusts and investment trusts.
Mutual Funds play an important role in helping small investors to achieve international diversification. Just as diversification across companies is beneficial in improving the risk-return trade-off, so international diversification improves it still further. Small investors find it difficult and costly to buy and sell foreign shares, but mutual funds are able to access foreign markets and spread the costs over large numbers of investors. Investment opportunities for small investors are thereby greatly enhanced.
