How do I avoid risks?
You cannot totally avoid risks. But you can control your exposure to risks to an acceptable level. This doesn't mean sticking to dull investments - it means making sure you understand exactly what you are investing in and recognise the potential problems. Once you have identified the risks, you can take steps to manage them.
How to do that?
You should look at your investment objectives, risk tolerance and constraints, and plan accordingly. Don't invest in an area which carries higher risk than you are prepared to take.
Take the trouble to learn about the products you wish to invest in. Read prospectuses, offer documents, annual reports and announcements carefully. Pay attention to the "risk factor" sections or "risk warning" messages. If in doubt, seek professional advice.
Diversification is a good antidote. There is a huge range of investments available such as stocks, bonds, insurance products, saving schemes and bank deposits. Mutual funds offer a wide range of options to fit different investment objectives. Spread the nest eggs around carefully. Avoid putting all your money into a single investment.
Long-term investment in sound assets is also viable. Research has shown that short-term fluctuations in stock markets even out over long periods, but keep a careful watch on any structural change in your investment.
Derivatives are not necessarily the high-risk cowboy. Used tactfully, they could offer a hedge against risk, rather than a greater exposure. For example, to avoid the impact of a falling stock market on your stock portfolio, you can consider shorting futures or buying put options.
In order for your hedging strategy to be effective, remember to pick futures or options contracts in which the underlying assets correspond to your holdings. So, HSI futures would not be the ideal tool to hedge the risk of a portfolio of China concept stocks if they are not HSI constituent stocks! The better alternative would be the MSCI China Free Index futures.
Another critical factor is the value of your futures or options positions vis-a-vis the size of your stock portfolio. Exchange-traded futures or options have standard contract sizes; therefore, they may not enable you to have a perfect hedge, meaning that it is possible of over-hedging or under-hedging.
Everything is done. Can I sit back and wait for the harvest?
You should re-examine the risk profile of your investments from time to time to ensure that they suit your risk tolerance and expectations. Moreover, if you hold derivatives for hedging purpose, you may need to adjust the size of your derivatives position according to changes in the value of your stock holdings. This is known as dynamic hedging.
Always be prepared for the worst. Take hard look at what could go wrong with an investment, or the sort of personal circumstances which could change suddenly.