Diversification of Stock Market Risk

Investment diversification is a type of risk management that used by investors and refers to the spreading of investment capital through multiple financial instruments and/or economic sectors. An example of diversification is stock ownership across a number of industries such as oil, utilities, biotechnology, retail etc. Diversification is similar to hedging in the sense that it is employed to lighten negative impacts from downturns on a specific financial instrument, economic condition/sector, and localized investments.

Many people diversify their money in different ways. For example, someone may put money into a house, have a savings account, own jewelry, use a money market account, hold certificates of deposit (CD's), and save through Individual Retirement Accounts (IRA's) or a pension fund. This is diversification in the sense if one or other of these investments falls through, there is another to relieve the overall risk to one's net worth. The hallmarks of diversification are listed below:

• Distributes money across an array of investments
• Shields investors from volatile fluctuations in prices
• Broader investment net may capture otherwise unrealized capital gains
• Allows riskier investments while simultaneously limiting exposure to associated risk

Diversifying through mutual funds

Diversifying risk is easy to do if one has tons of money to spread around. However, for those who don't have millions of dollars, mutual funds do. What's more, mutual funds often consider diversification an essential part of their investment strategy even if it is just within one economic sector.

For around the first 30 investments an investor or mutual fund makes, the level of risk declines significantly, especially if those investments are across different industries. However after a certain point, the lowering affect diversification has declines making the risk to number of investment ratio change less and less. A few ways diversification in the stock market takes place including through mutual funds are listed below:

1. Diversified Mutual Funds
2. Investment in international as well as domestic stocks
3. Time spread investments i.e. dollar cost averaging
4. Selection of stocks that span a number of economic sectors
5. Investment in large cap, mid cap as well as small cap stocks and pink sheets
6. Ownership of stocks, stock mutual funds and exchange traded funds
7. Diversification through investment in multiple stock exchanges.

Other Types of Investment Diversification

Diversification can be achieved in a number of ways and at varying levels of risk. One can diversify through the methods listed above or one can diversify using multiple financial instruments. Some examples of this type of diversification includes the following methods:

• Low Risk Diversification

1. Low risk mutual funds such as precious metals, utilities and bond funds
2. Treasury Bonds, Savings accounts, Australian Government Bonds
3. Investment through IRA's, Life Insurance Policies and Certificates of Deposit

• Medium risk diversification

1. Investment in index funds
2. Diversification through middle capitalization and large capitalization companies
3. Capital investment in Bonds, stocks and higher risk mutual funds

• High risk diversification

1. Investment across a range of small capitalization companies
2. Diversification through a number of risky exchanges such as foreign exchange, futures and growth sectors of the economy.

Risks Typically Associated with Non-Diversification:

When one does not diversify, one's net worth can decline dramatically. An example of this is the Tech bubble of the late 1990's and the Housing Bubble of the middle 2000's. If an investor had all their money in either of these industries after the bubble burst they could have lost a great deal of money.

An economic 'bubble' does not have to burst for an asset class or industrial sector to have a correction of 10-20% because there are many integrated market forces that drive prices of financial instruments outside of abnormal pricing. While diversification does not eliminate all one's investment risk, it can present some very safe options depending on how risky the investments are.

How one diversifies is also important because as with any investment strategy there are many different ways to diversify. Some methods are better than others. For example, if one diversifies in secure and Government backed financial instruments one's risk will be lower than if diversification takes place through high risk stocks across a number of industries. Also the choice of investments one chooses to diversify with can create a combination of risk and return that is ideal for an individual investor.

In summary, investment diversification limits but does not eliminate risk. The safer the investments that are diversified, the lower the overall risk will be. Diversification can be achieved through mutual fund investing as well as through investment in multiple asset classes and financial vehicles. The benefits of diversification are well known and considered a beneficial investment strategy.

How to Survive a Stock Market Crash

To survive a market crash it is helpful to have a sound investment strategy and a suitable back up plan should the stock market crash. A stock market crash is thought of as a dramatic large and/or 20% or more decline in stock indices such as the Nasdaq, Dow Jones or S&P 500. Surviving a stock market crash is what many investors and financial institutions had to do in the fall of 1929 and again on October 19, 1987, also dubbed 'Black Monday'.

The 'flash crash' of May 2010, caused market regulators to re-consider electronic fail safe mechanisms to prevent sudden heavy selling below a certain percentage drop in an index such as the Dow Jones Industrial Average. This can prevent a crash from occurring in the sense that it may lessen investor fear and more sell orders. Should such mechanisms not stop the market from crashing, or dropping heavily over a relatively short period of time, there are a few strategies for surviving a stock market crash.

Stock market crash loss reduction

Reducing loss in the event of a stock market crash is essential when surviving a stock market crash as this allows an investor to financially see another day. Traditional investing plans such as age based investing is a factor to consider overall, but these traditional methods of investing do not necessarily protect all one's assets from a wide spread stock market crash.

• Stop Loss Orders

Different investors have different loss comfort levels. Some can feel fine with losses of 20% whereas others start feeling worried at 5%. Finding one's comfort level and sticking to a pre-determined loss acceptance will prevent one from losing more money in the event the stock price falls dramatically lower. Stop loss orders are a financial mechanism that allow one to set a maximum loss amount before the stock automatically sells at market or pre-set prices.

• Diversification

A cardinal rule of safe investing is to diversify investments i.e. put money in different places. Real estate, Treasury Bonds, Certificates of Deposit and regular checking accounts are all safe places to put money. What's more, if the crash leads to a recession or worse, Gold and precious metals exchange traded funds may be a good idea as well.

• Stay Informed

Being informed of World events, economic trends and sector performance can assist in predicting potential declines or even crashes in the stock market. However, it is not always possible to know with absolute certainty what will happen. Even complex and sophisticated computer modeling programs can't predict every financial event.

• Don't overly invest in risky stocks

Some stocks do better than other stocks during stock market crashes. One cannot easily lose what isn't made available for easy loss, and placing money in time tested large blue chip companies may help do just this. Another options is simply not to invest in stocks at all, but rather Bonds or Commodities i.e. By not investing, or investing conservatively, one may earn a lower yield but may also be assured the investment is safer and more secure during times of market volatility.

Surviving after the stock market crash

There are also a few strategies that can be taken advantage of after a stock market crash, each of which is not a guarantee of success, but rather a method based on outcomes with a certain amount of probably. The first of these strategies is to sell short after which more self-involved methods may be necessary.

• Sell Short

If the crash is going to continue and lead to more declines in market valuations, it might be a good idea to sell short i.e. reverse invest. To sell short means investing with a pre-determined strike price (sell price). If the stock valuation declines below a certain point, the investor can make a profit from selling at the higher strike price.

• Change Investing Strategy

If one has lost the majority of or all of one's investment due to a stock market crash, the investment strategy used in any, probably wasn't all that good to start with. A more conservative, better researched, and safer investment strategy can save potential heartache and financial headaches. As mentioned above, selling short is one such technique to be used.

• Employment

Through employment, one can earn extra money to save for a rainy day such as poor investment decisions and/or a stock market crash. Employment is always a good hedge for investing and a good stand by when investments don't yield.

• Start Over

Whether one likes it or not, there isn't much choice but to start building wealth all over again if one loses money in a stock market crash. To do that takes further investment with an improved investment strategy.

• Prioritize

If there is no money left to invest, the priority is no longer to build wealth but to live to see another day. In such a case survival becomes the priority, after which building a new investment portfolio may become an option.