How should an investor mitigate the risk in equity?

Less stocks can already provide diversification. That is one of the most common mistake committed by investors. The belief was inculcated by media and books reporting the results of high-profile stock pickers, as well as the thought the great investors own a few stocks and do not lose money as long as they possess them for a long time period. Although these irrational reasonings may be true, such rationalizations can do little to ease equity risk. Hence, an irrational conclusion.

Looking at the statistical analysis, an investor can diversify away company-specific peril and be left with the systematic risk exposure in equities by obtaining around 30 stocks. Most investors fail to realize is this practice does nothing to offset the risk in possessing certain asset classes like large or small cap stocks. Even if a trader holds the entire S&P 500, he can still endure substantial systematic risk connected to US large cap stocks.

That is why investors should also invest on global stocks. Global equity markets are very huge and have several commonly accepted, distinct equity asset class. Each has its unique valuation characteristics, risk levels, factors, and reactions to different economic situations.

Granted an investor has both American and global stocks, will that be enough to make his portfolio diversified? Unfortunately, no. An investor cannot diversify by only choosing stocks. For a sensible diversification, one has to invest also in mutual funds, exchange-traded funds, or other types of assets. And he must be very careful when it comes to picking mutual funds, just like choosing an individual stock.

Claims which say holding mutual funds with various asset class exposures are not true. Investors must remember mutual fund names are chosen for marketing purposes and slightly affects the exposures of their assets. Lots of mutual funds tend to grab opportunities and move among several asset classes. When looking for mutual funds, ask for a snapshot and some sort of objective analysis outlining their specific exposure, as well as their historical asset class exposure over time.

Some investors believe index funds leave a lot of money on the table since good stock pickers have a chance to beat the market. Conversely, there is no such thing as predictive financial model. Moreover, a research shows most professional money managers cannot defeat their indexes net of fees. According to a 2007 report by Morningstar, only 36% of large cap money managers actually outmatch their S&P 500 net of fees. But, indexing is cheap. The types of mutual funds available to an investor levies a rate between 1% and 2%, but an index fund charges around 0.2% to 0.5%.

What is the best way to alleviate equity risk in a portfolio? Spread the assets significantly. Do not put all the eggs in one basket. Retaining a few stocks or several mutual funds won’t be sufficient. A real equity diversification entails having stocks within many equity asset classes throughout the globe, and setting up meaningful allocations.