Diversification and Monitoring Stock Allocation Rule and Market Risk

When investors decide to invest, their first step is often a decisive step. They might need to decide if their investment should be into a specific, single asset class or into multiple asset classes. Choosing to invest in a single asset class is common as it avoids having to make complicated investment decisions.

Investing in stock has its share of perils and unpredictable outcomes from real world events and real time trading. This makes it all the more important for the investor to choose stocks carefully and wisely when expanding the portfolio by diversifying stock options.

In diversification, investment flows into various portfolios to maximize returns with minimum risk. Instead of focusing on one portfolio, diversification encourages investing in different and multiple companies, markets, sectors or industries.

Although there is no assurance that diversification protects from all risk, it is acknowledged as a sound technique to achieve long-term financial goals with minimum risk as different stocks are impacted differently by the same economic event. The long-term value it gives on the investment can help manage the risks involved.

There are many benefits when diversifying your investment into various assets. Primarily, it reduces both the impact from market volatility and the time spent monitoring the investment portfolio. In addition, the investor’s capital exposure or risk on a particular asset is reduced.

Nonetheless, it is important that investors monitor their investment. Monitoring is systematic check and balance process of analysing the performance of an investment instrument towards achieving its objectives – and this analysis could guide future investment decisions.

Although diversification and monitoring process does not guarantee against loss, both are important elements in reaching long-term investment goals while keeping risk to a minimum.

Stock Allocation Rules are commonly cited rules meant to simplify the allocation of assets. A simple rule of thumb followed by traders is to not risk more than 2% of the entire portfolio on a trading position. For example, if your investments are worth RM100,000, invest no more than RM2,000 in an open position.

Another commonly cited rule of thumb states that, ideally, an investor should hold a percentage of stocks equal to 100 minus their age. So, for a 40-year-old, 60% of the portfolio should be equities and the other 40% should be invested in safer assets like high-grade bonds and government debt.

However, financial institutions and investment firms with large funds usually follow a more complex stock allocation rule such as the Modern Portfolio Theory (MPT). This theory relates to those risk-averse investors, whereby a personalised portfolio is built to optimise the expected return and to emphasise the level of market risks as an essential part of achieving a higher reward. Although it might be that the assumptions of MPT are flawed to a certain extent, combining assets of different classes and allocating them using MPT is still a reliable method to reduce volatility in an investment portfolio.

While diversification and monitoring are important parts of investing, you must bear in mind that all investment is exposed to risk. Vulnerability to events that affect outcomes is one such risk – and this could be in the form of a systematic risk or an unsystematic risk.

Typically, a systematic risk (also known as market risk) has it effects on the entire market or an entire segment of the market and is usually correlated with inflation rates, exchange rates, interest rate movements, political instability, catastrophes, epidemics and pandemics (like Covid-19) and war. Diversification might not be of much assistance against a systematic risk as the entire market is likely to be affected by the event or situation.

On the other hand, an unsystematic risk is an inherent, industry-specific risk that arises when investing in specific companies and the industries or sectors they are in. The fear of losing in positions arises from movements in the market prices that would affect a specific company’s or the industry's performance. In such a scenario, diversification would be a powerful defence against loss as investment spread out over many companies or sectors would be protected from events or situations that affect only one specific company or sector.

Given that market performance can be quite unpredictable, especially when the market is volatile, investors must remain wary about their investment risks and adopt recovery planning measures to ride out such risks.

The tools of fundamental and technical analysis could provide a comprehensive risk management plan. A protective stop is used to safely get out of a position either when a predefined profit target is achieved, or when a predefined loss limit is reached.

An investor may also calculate potential trade entry and exit points by assessing the reward and risk of each position. In a way, this can assist investors to identify the trade setups and investment opportunities prior to investing.

To reach your long-term goals, balancing the risk and reward factors tied to your investment is an invaluable step. Identifying the right combination of investment with continuous rebalancing and monitoring will make a remarkable difference to the returns from your investment.