How To Reduce Your Risks When Investing In Stocks
This article will address ways to reduce your risks when investing in the stock market! Is your fear of risk keeping you from growing your money by investing in stocks? Are you settling for lower returns on your money than you could be earning?
Is it possible to achieve high returns with stocks and do so with “low” risk? Yes! If an investor learns to manage their financial risk instead of avoiding it!
There is a lot of doubt among individuals when it comes to investing in the stock market. Do not let the fear of risk, or a lack of financial knowledge, keep you from getting started investing in stocks. With the right skills investing in stocks doesn’t have to be scary!
It is only natural that investing in stocks involves some risk. All investments require some degree of risk. I’m sure everyone has heard the phrase: “No Risk…No Reward!”
Manage Your Risk Instead of Avoiding It
However, smart investors manage financial risk not “shun” it! They know that stocks over the long run rewards risk and that the financial rewards from investing in stocks are well worth it! History has proven that no other investment, long-term, has outperformed the returns on stocks!
Warren Buffett, the greatest investor of all time, is quoted as saying, “Risk comes from not knowing what you’re doing.” In other words, Buffett only takes “educated” risks! He only invests in companies after thorough research.
Buffett also makes sure he does not invest outside of his “circle of competence.” In other words, he only invests in companies he understands and is familiar with.
Individual investors should try not to invest outside of their area of expertise. Doing this could backfire. If an individual doesn’t understand the company they should take a pass and move on to another company.
Learn To Invest Yourself
One way you can reduce risk is by learning how to invest yourself and not turning your money over to someone else to invest for you! Make your own money decisions! Educate yourself by reading everything you can on investing in stocks. Having knowledge will reduce your risk.
Today, it is easier than ever to research a company online on financial websites. Study and familiarize yourself online with the company’s line-of-business, fundamentals (statistics), and management. Make sure you analyze the company, thoroughly, before clicking your mouse, and purchasing a company’s stock.
Invest For The Long-Term
Another way to reduce your risk is to invest long-term. Hold onto your stocks and try not to get frustrated with “short-term” market swings. These price fluctuations are often meaningless!
Be patient and stay the course if the reasons you bought the stock in the first place still apply! Patience is very important when investing in the stock market! Investing long-term will lessen your risks and results in higher overall returns.
Make Sure Your Portfolio Is Diversified
Another way an investor can reduce risk is to diversify their investment portfolio. With diversification, an investor chooses a portfolio of different types of stock investments. An individual can diversify by adding unrelated industries and different sectors to their stock portfolio mix. For instance, an investor could invest in the financial, technology and utility sectors.
There are nine different stock sectors to invest in. The nine sectors are Financials, Energy, Healthcare, Technology, Consumer Staples, Utilities, Materials, Consumer Discretionary, and Industrials.
For example, an investor would not be properly diversified if their entire portfolio consisted only of tech stocks and utility stocks. Investing in this manner can be very risky! The investor’s goal could be to purchase stocks in all nine sectors in order to properly diversify their portfolio. Ideally, the investor should aim for a mix of large and small companies in each sector. Investing in this way helps to eliminate any one sector’s downside in the market.
Or, the investor could choose to diversify by market cap. Market capitalization is the market value of all outstanding shares of a public company. For example, investors could choose large caps, mid caps and small-cap stocks in their efforts to be properly diversified.
An investor, also, would be taking on way too much risk if their “only” holding was in their employer’s stock. This is a bad idea and would be way too risky! If the company they worked for were to go out of business not only would they lose their job but also the money they invested in their company’s stock and retirement monies. Most experienced investors are very familiar with the saying, “Don’t put all of your eggs in one basket.”
Risk Aversion
In an effort to reduce risk, the “risk-averse” individual may buy blue-chip stocks. “Risk aversion” is when an investor is faced with two investments, with comparable returns, and the investor chooses the investment with the lowest risk. The risk-averse individual aims for less uncertainty. A blue chip stock is a stock in a large well-known company with a billion dollar market cap. Some examples of blue-chip companies are Amazon, Facebook, and Berkshire Hathaway.
Some investors buy into mutual funds in an attempt to eliminate risk. A mutual fund does have the advantage of diversifying an individuals investments. However, many funds do not beat the market’s returns and perform poorly. Shareholders that take this route are turning their money decisions over to a manager. This, in itself, can entail some risk.
Blue chip stocks and mutual funds are not necessarily “less” risky and may not guarantee higher returns on your money. However, many “uninformed” investors will choose them believing they are lessening their overall risks.
Unfortunately, loss aversion causes many investors to be “too” conservative with their investments! Hence, bond investors are settling for “lower” returns on their money than stocks could have provided. The returns on bonds have been unable to beat the returns on stocks long-term.
Some investors may invest a large amount of their money in bonds even though their investing time horizon is decades away! This is risky not only because of lower returns but also because bonds do carry risk. (See my article: “Is Investing In Bonds Risky?)”
Another example of “loss aversion” is when an investor holds onto a losing stock too long! This can prove risky with the investor often losing money in the process. Selling this stock would mean the investor had made a mistake. Rather than facing up to their mistake, the investor holds onto this stock in an effort for it to go back up. The investor, many times, would have been better off selling this losing stock and reinvesting their monies in a more profitable company.
Numerous studies have indicated that individuals dread their losses with stocks more than they appreciate their gains! The pain of a loss is much more severe to many investors than their enjoyment of gains!
In conclusion, we need to become “smarter” investors and learn not only how to manage our investment risks but also, how not to avoid them! An investor doesn’t need to take big risks with their stocks. In an effort to eliminate risks, intelligent investors will invest the time to learn everything about a company before they purchase its’ stock. They can eliminate a lot of risks, and make extraordinary profits, just by doing the necessary stock homework!
An investor can “lessen” their risk in the market with determination, the proper financial education, patience, discipline, and the right skills. Investing long-term and diversifying your portfolio also serves to decrease an investor’s overall risk. So, don’t let the fear of risk stop you from maximizing your wealth by investing in stocks.
