The essence of risk management is allocating the assets in your portfolio in such a way that they suit your personal risk tolerance. The simplest way to manage risk is through diversification.
Diversification is important in almost every portfolio as it decreases risk ‘for free’. In other words, simply by dividing your assets up between regions and asset classes, the total risk of the portfolio drops without needing to decrease the risk (and potential return) of the constituent assets.
Diversification can be very complex if the assets in your portfolio are mainly individual fixed income bonds and stocks. However, there are some mutual funds or fund of funds (a fund that invests in other funds) that aim to include enough assets to be wholly diversified themselves. Hedge funds aim to be non-correlated – this means that they don’t move with the market at all. They rarely completely achieve this. Many people diversify their portfolio through hedging, meaning they will purchase an investment that runs counter to their other primary investments in order to decrease the total risk. This is often done to offset currency risk but other people buy debt (fixed income bonds) to offset equity (stocks and shares) risk.
Having said all of this, the Zulu Principle, articulated by Jim Slater, states that focus is the key to making excellent money in the markets. By just focusing to what you (or your IFA) actually know well, the choices made can be better informed and stand more chance of pulling away from the market.
The reality of the situation is that intelligent diversification through hedging is a necessity, but investing in something just for the sake of diversifying your portfolio is a mistake. A loss is still a loss and it rarely matters if it helped to diversify your portfolio or write off a tax loss. However, on the other side of the coin, risk has a value, and lowering risk is in effect giving you a monetary return.
If this is beginning to sound contradictory and overly intricate, rest assured the mathematics attached to risk management are some of the most complex around. The good news is that the ability to invest offshore means your options are dramatically increased and a good international financial adviser will be able to plan your risk against this broader backdrop.