How to Reduce Your Risk when Investing in Stocks

The title of this article is actually something of a misnomer.  The reason is that if one is taking substantial risk, one is not investing, but rather speculating or trading.  In investing, while one is putting money at risk the odds are substantially in the investor’s favor.  With speculating the odds are slightly in one’s favor.  In trading the odds are even or maybe stacked against the trader.  Just like gambling, trading and speculating are obviously more exciting than investing, and many simply fool around with stocks for the entertainment value.  Those who are serious about making money in the market, however, would want to put the odds in their favor since this both increases the chances of growing one’s wealth and reduces the amount of time required to manage the accounts.

The two factors three factors that affect risk are diversification, stock selection, and time period.

One way to reduce risk is through diversification.  Because things can happen to single stocks (scandals, lawsuits, bad management) it is safer to buy several different stocks rather than concentrating all of ones funds in a few stocks.  Diversification also reduces the impact of poor stock choices.  If one buys three different stocks, the poor performance of one of the companies can be offset by good performance in the other two.  Diversification into more than one industry also reduces risk since good performance int he retail sector can offset downturns in the technology segment, for example.  Finally, diversification into different types of investments, for example, buying stocks, bonds, and real estate investment trusts (REITs) reduces risk because the different sorts of investments may perform differently from each other so market conditions that cause one type of investment to decline in price may cause other types to increase in value.  When this is the case the two types of inc=vestmebnts are said to be “uncorrelated.” 

Diversification is a two-edged sword, however.  By buying several stocks or different types of investments one also limits one’s possible gain to the gain of the markets in general.  While this is fine when one has a large account and is simply trying to keep up with inflation and generate a some income, for the investor just starting out who does not have a lot of money it may be worth taking slightly more risk for the possibility of faster gains.  In general it is best to concentrate positions yet never hold more in a  single position than one is willing to lose.  An investor with a large account might therefore hold 50-100 stocks, or a set of mutual funds that invest in hundreds of stocks, while the investor starting out may only hold 3-5 stocks. 

Even the beginning investor can reduce her risk, however, through the type of stocks she selects.  By purchasing the stocks of companies that have shown a history of steady growth over long periods of time – and that still have room to continue to grow – she can reduce risk by planning to hold these stocks for long periods of time.  In that way even if market fluctuations cause short-term declines in stock prices, eventually the growth of the company’s earnings will cause the stock price to rise.  There is therefore no market timing required – just hold onto the shares and chances are in one’s favor that the price will increase.

This would mean avoiding cyclical stocks – those that do well in good times and poorly in bad – and look for stocks that are able to generate increases in earnings each quarter.  These stocks tend to be in areas such as retail, restaurants, hotel chains, and technology (particularly software and computer sales).  Areas to avoid would be airlines, semiconductors, and basic material producers.  Large companies that have already completed growing and now are simply holding market share and paying out dividends would also not be appropriate because they lack the growth capability of smaller growth stocks.  

Finally, time horizon affects risk.  Investing for short periods of time is more difficult because short-term pricing of stocks is unpredictable.  Stocks sometimes go up or down for no apparent reason, mainly due to the trading activities of various individuals and entities.  A stock that sets record earnings but misses people’s expectations by a penny could fall several percentage points.  Likewise, a company that lays off hundreds of employees can shoot up in price.  If one selects the type of companies described above and holds them for significant periods of time (many years), the effects of these seemingly random factors will be mitigated.  Stocks are also affected by interest rates and other economic factors that are unpredictable.

If a company increases earnings at a 15% rate per year over long periods of time the price of the stock will grow by about 15%.  There may be times when it grows faster or times when it grows slower but stock price will follow earnings given sufficient time.  It is therefore much easier, and less risky, to find stocks that reliably grow earnings and hold them then try to predict stock behavior over short periods.  This leads to boring trading, just buying stocks and almost never touching them, but if one really wants to invest to grow wealth rather than just be entertained, that is the way.

To ask a question, email or leave the question in a comment for this blog.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. In addition the writer of this blog is not an accountant and writings should not be taken as tax advice which should be left to a CPA.  Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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