As stock and bond markets nosedive over global concerns of high crude oil prices, inflation and the economy, a well-designed strategy of diversification within an investment portfolio will help reduce the nightmares of stock investors. Certain basics of share market investing come in handy in these troubled times
One goal of diversification is to lessen the likelihood of substantial losses while still providing the opportunity for attractive longer-term rates of return. This is done by buying shares of companies which are not dependent on each other or on same business cycle. In other words, their values may move in different directions at different times. For example, during the past year, commodity prices such as gold and oil among others have moved higher while stock prices have moved lower.
One method of diversifying a stock portfolio is to invest in companies within different industry groups or sectors. For this purpose, it is helpful to look at a broad measure of stocks, such as the Nifty 50 or the BSE Sensex 30 companies. The Nifty is comprised of the stocks of 50 widely-held companies and is often used to measure the performance of the Indian stock market.
Stocks in the index are selected by a committee at SEBI. Each stock’s weighting in the index is proportionate to its market capitalization or value, which is typically calculated by multiplying the number of shares of stock outstanding by the current price per share. The shares of companies like Reliance, Infosys, Bharti, ONGC etc have a heavy weightage in the stock market index.
The stocks within the Nifty and Sensex are categorized into broad sectors or industry groups with some sub-groups. The composition of the sectors in the NSE and BSE index keeps changing as some companies are removed and other added in the index according to their importance, market capitalization and other factors in the economy.
By owning stocks across several of the major industry groups, an investor can lower the volatility or risk of a stock portfolio. At any point in time, however, there may be some securities moving lower in value while others are moving higher. It may become tempting to sell the securities moving lower and buy more of whatever is moving higher. By doing so, however, the diversification within the portfolio could be destroyed, leaving the investor with a highly focused group of securities instead. While this may work fine for a while, it could ultimately end in disaster as happened with technology stocks during the dotcom bust and, more recently with the financial sector and real estate.
Along with this idea of diversification I would like to add something from Warren Buffett’s experience in investing. Everyone wants to become rich and make more money but do we have his patience and temperament?
His approach is simple: Buffett buys good companies with healthy balance sheets and strong cash flow, a product or service that he understands, and strong management that will continue running the business.
He is also a patient man, a buyer of companies and rarely a seller. Buffett has stated that with the companies he owns, he would not be concerned if trading at the stock exchanges was halted for five years. (How would you deal with that? Are you invested in companies which you know will grow and pay dividend over the years to its share holders?)
So what does this have to do with the average stock investor?
Buffett’s method is all that is needed to be successful in the share market investment world; however, there is not much likelihood that many can follow Buffett |
