Now, before you go crazy thinking that stock investing carries so much risk that you may as well not get out of bed, take a breath. Minimizing your risk in stock investing is easier than you think. Although wealth-building through the stock market doesn’t take place without some amount of risk, you can practice the following tips to maximize your profits and still keep your money secure.
Table of Contents
- 1. Gaining knowledge of stock trading
- 2. Staying out until you get some practice
- 3. Make sure you are financially secure before investing in any stock
- 4. Diversifying your investments
- 5. Understand your Risk Tolerance
- 6. The Asset Allocation Strategy
- 7. Invest in Blue-Chip Stocks
- 8. Monitor Regularly
- Final Words
1. Gaining knowledge of stock trading
Most people spend more time choosing a $20 entree from a restaurant menu than deciding where to invest their next $5,000. The greatest risk for new investors is a lack of knowledge, so learning how to minimize that risk is the first step.
As you become more familiar with the stock market – how it works, factors that affect stock value, and so on – you will be able to steer clear of its pitfalls and maximize your profits. It is this knowledge that enables you to increase your net worth as well as minimize your risks. You should do your research before you place your money anywhere.
2. Staying out until you get some practice
Don’t invest in stocks if you don’t understand them! Most people should consider investing in stocks to some extent. But that does not mean you have to be 100 percent invested 100 percent of the time. When you don’t understand a particular stock (or stocks in general), stay away from it until you do. Instead, give yourself an imaginary amount of money, such as $100,000, and explain why you want to invest (this is known as simulated stock investing).
Pick a few stocks you think will increase in value and track them for a while. Watch what happens to the stocks you choose when certain events occur and understand how the stock price goes up and down. During your learning period, you will get better at choosing individual stocks as you learn more about stock investment.
3. Make sure you are financially secure before investing in any stock
There could be a whole book written about what to do before investing. Prior to taking the plunge into the stock market, you should make sure that you are financially secure. Get a financial planner to review your situation if you are not sure how secure your finances are.
You can prepare your finances before you purchase your first stock by doing the following:
Make sure you have an emergency fund. You should set aside three to six months’ worth of your gross living expenses somewhere safe, such as in a bank account or Treasury money market fund if you suddenly need cash.
Pay down your debt. Americans have continued to overindulge in debt in recent years, which was a major economic problem in the late 1990s. In 2015, the level of debt across the board reached new all-time highs.
Ensure that your job is as secure as possible. Do you keep your skills up to date? Do you work for a strong, growing company? What about your industry?
Ensure that you have adequate insurance. If you or a family member becomes ill, dies, becomes disabled, etc., you should have enough insurance to cover those needs.
4. Diversifying your investments
Diversification is a strategy for reducing risk by spreading your money across different investments. It’s a fancy way of saying, “Don’t put all your eggs in one basket.” But how do you go about divvying up your money and distributing it among different investments?
The easiest way to understand proper diversification may be to look at what you shouldn’t do:
Don’t put all your money in one stock. Sure, if you choose wisely and select a hot stock, you may make a bundle, but the odds are tremendously against you. Unless you’re a real expert on a particular company, it’s a good idea to have small portions of your money in several different stocks. As a general rule, the money you tie up in a single stock should be money you can do without.
Don’t put all your money into one industry. I know people who own several stocks, but the stocks are all in the same industry. Again, if you’re an expert in that particular industry, it can work out. But just understand that you’re not properly diversified. If a problem hits an entire industry, you may get hurt.
Don’t put all your money into one type of investment.<span style=”font-weight: 400;”> Stocks may be a great investment, but you need to have money elsewhere. Bonds, bank accounts, treasury securities, real estate, and precious metals are perennial alternatives to complement your stock portfolio. Some of these alternatives can be found in mutual funds or exchange-traded funds (ETFs). An exchange-traded fund is a fund with a fixed portfolio of stocks or other securities that tracks a particular index but is traded like a stock.
Okay, now that you know what you shouldn’t do, what should you do? Until you become more knowledgeable, follow this advice:
Keep only 5 to 10 percent (or less) of your investment money in a single stock. Because you want adequate diversification, you don’t want overexposure to a single stock. Aggressive investors can certainly go for 10 percent or even higher, but conservative investors are better off at 5 percent or less.
Invest in four or five (and no more than ten) different stocks that are in different industries. Which industries? Choose industries that offer products and services that have shown strong, growing demand. To make this decision, use your common sense (which isn’t as common as it used to be). Think about the industries that people need no matter what happens in the general economy, such as food, energy, and other consumer necessities.
5. Understand your Risk Tolerance
How much risk is appropriate for you, and how do you handle it? Investors’ risk tolerance refers to their ability to endure the risk of losing their capital (i.e., invested). Age and current financial obligations are the main factors that influence risk tolerance.
Before you try to figure out what risks accompany your investment choices, analyze yourself. Here are some points to keep in mind when weighing risk versus return in your situation:
Your financial goal:<span style=”font-weight: 400;”> In five minutes with a financial calculator, you can easily see how much money you’re going to need to become financially independent (presuming financial independence is your goal). Say that you need $500,000 in ten years for a worry-free retirement and that your financial assets (such as stocks, bonds, and so on) are currently worth $400,000. In this scenario, your assets need to grow by only 2.25 percent to hit your target. Getting investments that grow by 2.25 percent safely is easy to do because that’s a relatively low rate of return.
The important point is that you don’t have to knock yourself out trying to double your money with risky, high-flying investments; some run-of-the-mill bank investments will do just fine. All too often, investors take on more risk than is necessary. Figure out what your financial goal is so that you know what kind of return you realistically need.
Your investor profile: Are you nearing retirement or are you fresh out of college? Your life situation matters when it comes to looking at risk versus return.
If you’re just beginning your working years, you can certainly tolerate greater risk than someone facing retirement. Even if you lose big time, you still have a long time to recoup your money and get back on track.
However, if you’re within five years of retirement, risky or aggressive investments can do much more harm than good. If you lose money, you don’t have as much time to recoup your investment, and odds are that you’ll need the investment money (and its income-generating capacity) to cover your living expenses after you’re no longer employed.
6. The Asset Allocation Strategy
The term asset allocation refers to the practice of investing in more than one asset class for reducing investment risks and maximizing returns. We can choose from a wide range of assets such as equity, debt, mutual funds, real estate, gold, etc.
An asset allocation strategy involves investing in a combination of asset classes that are inversely correlated. Equities and gold, for example, underperform when one asset class is outperforming. Equity and gold are inversely related, so when equity performs well, gold underperforms.
For people in their 20s and 30s, having 75 percent of their money in a diversified portfolio of growth stocks (such as mid-cap and small-cap stocks) is acceptable. For people in their 60s and 70s, it’s not acceptable. They may, instead, consider investing no more than 20 percent of their money in stocks (mid-caps and large-caps are preferable). Check with your financial advisor to find the right mix for your particular situation.
7. Invest in Blue-Chip Stocks
Investing in blue-chip stocks or funds is the best way to avoid liquidity risk. When investing in debt securities, investors must check the credit ratings.
There are risks associated with all types of investment products. Earlier, we discussed the importance of considering one’s risk appetite when making an investment decision. It is important to ensure that investment decisions do not influence one’s lifestyle.
8. Monitor Regularly
One should monitor their portfolio regularly after considering all the factors above. Investing for the long run doesn’t mean that you ignore your portfolio. Regularly monitor the performance of your portfolio and conduct periodic reviews.
As a long-term investor, you should neglect short-term volatility, and only make changes when your investments demonstrate poor performance over an extended period. That’s why portfolio reviews should be done every six months. This is because some asset classes like equities tend to have short-term volatility.
A zero-risk investment portfolio is impossible because every investment involves some level of risk. However, if you implement the above 8 strategies, we can assure you that you will be able to find the appropriate balance between risk and return. In this way, you can continue to grow your investments and reach your financial goals.