This is part two in a four-part series about investing. Read part one here.
In an earlier article, I discussed considering the amount of risk you can handle before taking a financial decision.
The second question to ask is: How can you diminish your risk?
It goes without saying that you should not put all your eggs in one basket. This does not just mean not investing in the same share or bond, but also avoiding shares or bonds similar to ones you already invest in. Moreover, you should consider all available assets, eve intangible ones like property.
If you own property in Malta, work for a Maltese company, and own some Maltese government bonds, why would you even consider further investments in, say, a highly leveraged local property investment? In the extreme scenario of a complete recession in Malta, you would experience losses throughout all your assets: the value of your property will drop, your employer may reduce salaries or worse lay off people, and the additional investment might be worthless.
The same principle applies at corporate or national levels. Traditionally, financial corporations like insurers used to immunise their portfolios by structuring assets to ensure changes in interest rates would not significantly change their value in comparison with future liabilities. This practice has recently been replaced by the use of derivatives – complicated financial contracts whose value depends on some underlying asset.
Countries also face decisions on how to diminish financial risk. For example, as an oil importer, Malta hedged oil prices. Sadly this was done just before prices started going down. With the benefit of hindsight, we could have predicted oil price going down as supply was plentiful due to Iran’s eventual entry in the market and new extraction methods such as fracking, while demand was getting weaker due to China’s diminished growth. Hence, our hedging was not ideal and it would be so much easier if we had a crystal ball. Conversely, the current drive to use different sources of energy production is a wise move.
Diversification is important from a personal, business, or even national perspective. It would be ideal to consider investments in different industries and different currencies while taking into consideration taxation and the level of risk that can be taken on board, as I discussed last week.
Dominic is the director of the distance learning masters program in Actuarial Science at The University of Leicester. His other responsibility is taking care of a chilli plant – it died last September. You can send him love letters on Twitter - @domcortis
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