Stock Investing For Dummies, 5th Edition - Paul Mladjenovic (2016)
Part I. The Essentials of Stock Investing
Chapter 4. Recognizing Risk and Volatility
IN THIS CHAPTER
Considering different types of risk
Dealing with volatility
Taking steps to reduce your risk
Balancing risk against return
Investors face many risks, most of which I cover in this chapter. The simplest definition of risk for investors is “the possibility that your investment will lose some (or all) of its value.” Yet you don’t have to fear risk if you understand it and plan for it. You must understand the oldest equation in the world of investing — risk versus return. This equation states the following:
If you want a greater return on your money, you need to tolerate more risk. If you don’t want to tolerate more risk, you must tolerate a lower rate of return.
This point about risk is best illustrated from a moment in one of my investment seminars. One of the attendees told me that he had his money in the bank but was dissatisfied with the rate of return. He lamented, “The yield on my money is pitiful! I want to put my money somewhere where it can grow.” I asked him, “How about investing in common stocks? Or what about growth mutual funds? They have a solid, long-term growth track record.” He responded, “Stocks? I don’t want to put my money there. It’s too risky!” Okay, then. If you don’t want to tolerate more risk, don’t complain about earning less on your money. Risk (in all its forms) has a bearing on all your money concerns and goals. That’s why understanding risk before you invest is so important.
This man — as well as the rest of us — needs to remember that risk is not a four-letter word. (Well, it is a four-letter word, but you know what I mean.) Risk is present no matter what you do with your money. Even if you simply stick your money in your mattress, risk is involved — several kinds of risk, in fact. You have the risk of fire. What if your house burns down? You have the risk of theft. What if burglars find your stash of cash? You also have relative risk. (In other words, what if your relatives find your money?)
Be aware of the different kinds of risk that I describe in this chapter, so you can easily plan around them to keep your money growing. And don’t forget risk’s kid brother … volatility! Volatility is about the rapid movement of buying or selling, which, in turn, causes stock prices to rise or fall rapidly. Technically, volatility is considered a “neutral” condition, but it’s usually associated with rapid downward movement of stock because that means sudden loss for investors and causes anxiety.
Exploring Different Kinds of Risk
Think about all the ways that an investment can lose money. You can list all sorts of possibilities. So many that you may think, “Holy cow! Why invest at all?”
Don’t let risk frighten you. After all, life itself is risky. Just make sure that you understand the different kinds of risk that I discuss in the following sections before you start navigating the investment world. Be mindful of risk and find out about the effects of risk on your investments and personal financial goals.
The financial risk of stock investing is that you can lose your money if the company whose stock you purchase loses money or goes belly up. This type of risk is the most obvious because companies do go bankrupt.
You can greatly enhance the chances of your financial risk paying off by doing an adequate amount of research and choosing your stocks carefully (which this book helps you do — see Part 3 for details). Financial risk is a real concern even when the economy is doing well. Some diligent research, a little planning, and a dose of common sense help you reduce your financial risk.
In the stock investing mania of the late 1990s, millions of investors (along with many well-known investment gurus) ignored some obvious financial risks of many then-popular stocks. Investors blindly plunked their money into stocks that were bad choices. Consider investors who put their money in DrKoop.com, a health information website, in 1999 and held on during 2000. This company had no profit and was over-indebted. DrKoop.com went into cardiac arrest as it collapsed from $45 per share to $2 per share by mid-2000. By the time the stock was DOA, investors lost millions. RIP (risky investment play!).
Internet and tech stocks littered the graveyard of stock market catastrophes during 2000–2001 because investors didn’t see (or didn’t want to see?) the risks involved with companies that didn’t offer a solid record of results (profits, sales, and so on). When you invest in companies that don’t have a proven track record, you’re not investing, you’re speculating.
Fast forward to 2008. New risks abounded as the headlines railed on about the credit crisis on Wall Street and the subprime fiasco in the wake of the housing bubble popping. Think about how this crisis impacted investors as the market went through its stomach-churning roller-coaster ride. A good example of a casualty you didn’t want to be a part of was Bear Stearns (BSC), which was caught in the subprime buzz saw. Bear Stearns was sky-high at $170 a share in early 2007, yet it crashed to $2 a share by March 2008. Yikes! Its problems arose from massive overexposure to bad debt, and investors could have done some research (the public data was revealing!) and avoided the stock entirely.
Investors who did their homework regarding the financial conditions of companies such as the Internet stocks (and Bear Stearns, among others) discovered that these companies had the hallmarks of financial risk — high debt, low (or no) earnings, and plenty of competition. They steered clear, avoiding tremendous financial loss. Investors who didn’t do their homework were lured by the status of these companies and lost their shirts.
Of course, the individual investors who lost money by investing in these trendy, high-profile companies don’t deserve all the responsibility for their tremendous financial losses; some high-profile analysts and media sources also should have known better. The late 1990s may someday be a case study of how euphoria and the herd mentality (rather than good, old-fashioned research and common sense) ruled the day (temporarily). The excitement of making potential fortunes gets the best of people sometimes, and they throw caution to the wind. Historians may look back at those days and say, “What were they thinking?” Achieving true wealth takes diligent work and careful analysis.
In terms of financial risk, the bottom line is … well … the bottom line! A healthy bottom line means that a company is making money. And if a company is making money, then you can make money by investing in its stock. However, if a company isn’t making money, you won’t make money if you invest in it. Profit is the lifeblood of any company. See Chapter 11 for the scoop on determining whether a company’s bottom line is healthy.
Interest rate risk
You can lose money in an apparently sound investment because of something that sounds as harmless as “interest rates have changed.” Interest rate risk may sound like an odd type of risk, but in fact, it’s a common consideration for investors. Be aware that interest rates change on a regular basis, causing some challenging moments. Banks set interest rates, and the primary institution to watch closely is the Federal Reserve (the Fed), which is, in effect, the country’s central bank. The Fed raises or lowers its interest rates, actions that, in turn, cause banks to raise or lower their interest rates accordingly. Interest rate changes affect consumers, businesses, and, of course, investors.
Here’s a generic introduction to the way fluctuating interest rate risk can affect investors in general: Suppose that you buy a long-term, high-quality corporate bond and get a yield of 6 percent. Your money is safe, and your return is locked in at 6 percent. Whew! That’s 6 percent. Not bad, huh? But what happens if, after you commit your money, interest rates increase to 8 percent? You lose the opportunity to get that extra 2-percent interest. The only way to get out of your 6-percent bond is to sell it at current market values and use the money to reinvest at the higher rate.
The only problem with this scenario is that the 6-percent bond is likely to drop in value because interest rates rose. Why? Say that the investor is Bob and the bond yielding 6 percent is a corporate bond issued by Lucin-Muny (LM). According to the bond agreement, LM must pay 6 percent (called the face rate or nominal rate) during the life of the bond and then, upon maturity, pay the principal. If Bob buys $10,000 of LM bonds on the day they’re issued, he gets $600 (of interest) every year for as long as he holds the bonds. If he holds on until maturity, he gets back his $10,000 (the principal). So far so good, right? The plot thickens, however.
Say that he decides to sell the bonds long before maturity and that, at the time of the sale, interest rates in the market have risen to 8 percent. Now what? The reality is that no one is going to want his 6-percent bonds if the market is offering bonds at 8 percent. What’s Bob to do? He can’t change the face rate of 6 percent, and he can’t change the fact that only $600 is paid each year for the life of the bonds. What has to change so that current investors get the equivalent yield of 8 percent? If you said, “The bonds’ value has to go down,” bingo! In this example, the bonds’ market value needs to drop to $7,500 so that investors buying the bonds get an equivalent yield of 8 percent. (For simplicity’s sake, I left out the time it takes for the bonds to mature.) Here’s how that figures.
New investors still get $600 annually. However, $600 is equal to 8 percent of $7,500. Therefore, even though investors get the face rate of 6 percent, they get a yield of 8 percent because the actual investment amount is $7,500. In this example, little, if any, financial risk is present, but you see how interest rate risk presents itself. Bob finds out that you can have a good company with a good bond yet still lose $2,500 because of the change in the interest rate. Of course, if Bob doesn’t sell, he doesn’t realize that loss.
Historically, rising interest rates have had an adverse effect on stock prices. I outline several reasons why in the following sections. Because our country is top-heavy in debt, rising interest rates are an obvious risk that threatens both stocks and fixed-income securities (such as bonds).
Hurting a company’s financial condition
Rising interest rates have a negative impact on companies that carry a large current debt load or that need to take on more debt because when interest rates rise, the cost of borrowing money rises, too. Ultimately, the company’s profitability and ability to grow are reduced. When a company’s profits (or earnings) drop, its stock becomes less desirable, and its stock price falls.
Affecting a company’s customers
A company’s success comes from selling its products or services. But what happens if increased interest rates negatively impact its customers (specifically, other companies that buy from it)? The financial health of its customers directly affects the company’s ability to grow sales and earnings.
For a good example, consider Home Depot (HD) during 2005–2008. The company had soaring sales and earnings during 2005 and into early 2006 as the housing boom hit its high point (record sales, construction, and so on). As the housing bubble popped and the housing and construction industries went into an agonizing decline, the fortunes of Home Depot followed suit because its success is directly tied to home building, repair, and improvement. By late 2006, HD’s sales were slipping, and earnings were dropping as the housing industry sunk deeper into its depression. This was bad news for stock investors. HD’s stock went from more than $44 in 2005 to $21 by October 2008 (a drop of about 52 percent). Ouch! No “home improvement” there. The point to keep in mind is that because Home Depot’s fortunes are tied to the housing industry, and this industry is very sensitive and vulnerable to rising interest rates, in an indirect — but significant — way, Home Depot is also vulnerable. In 2015, HD was one of the few retail stocks that went up due to the rebounding real estate market. However, as interest rates ticked up at the end of 2015, the real estate industry started slowing down, which means that HD would be vulnerable in 2016.
Impacting investors’ decision-making considerations
When interest rates rise, investors start to rethink their investment strategies, resulting in one of two outcomes:
· Investors may sell any shares in interest-sensitive stocks that they hold. Interest-sensitive industries include electric utilities, real estate, and the financial sector. Although increased interest rates can hurt these sectors, the reverse is also generally true: Falling interest rates boost the same industries. Keep in mind that interest rate changes affect some industries more than others.
· Investors who favor increased current income (versus waiting for the investment to grow in value to sell for a gain later on) are definitely attracted to investment vehicles that offer a higher yield. Higher interest rates can cause investors to switch from stocks to bonds or bank certificates of deposit.
Hurting stock prices indirectly
High or rising interest rates can have a negative impact on any investor’s total financial picture. What happens when an investor struggles with burdensome debt, such as a second mortgage, credit card debt, or margin debt (debt from borrowing against stock in a brokerage account)? He may sell some stock to pay off some of his high-interest debt. Selling stock to service debt is a common practice that, when taken collectively, can hurt stock prices.
As I write this, the U.S. economy seems to be heading into a recession coupled with historic debt. In terms of gross domestic product (GDP), the size of the economy is about $18 trillion (give or take $100 billion), but the debt level is more than $70 trillion (this amount includes personal, corporate, mortgage, college, and government debt). This already enormous amount doesn’t include more than $100 trillion of liabilities such as Social Security and Medicare. Additionally (Yikes! There’s more?), some U.S. financial institutions hold more than 700 trillion dollars’ worth of derivatives. These can be very complicated and risky investment vehicles that can backfire. Derivatives have, in fact, sunk some large organizations (such as Enron in 2001, Bear Stearns in 2008, and the trading firm Glencore in 2015), and investors should be aware of them. Just check out the company’s financial reports. (Find out more in Chapter 12.)
Because of the effects of interest rates on stock portfolios, both direct and indirect, successful investors regularly monitor interest rates in both the general economy and in their personal situations. Although stocks have proven to be a superior long-term investment (the longer the term, the better), every investor should maintain a balanced portfolio that includes other investment vehicles. A diversified investor has some money in vehicles that do well when interest rates rise. These vehicles include money market funds, U.S. savings bonds (series I), and other variable-rate investments whose interest rates rise when market rates rise. These types of investments add a measure of safety from interest rate risk to your stock portfolio. (I discuss diversification in more detail later in this chapter.)
People talk about the market and how it goes up or down, making it sound like a monolithic entity instead of what it really is — a group of millions of individuals making daily decisions to buy or sell stock. No matter how modern our society and economic system, you can’t escape the laws of supply and demand. When masses of people want to buy a particular stock, it becomes in demand, and its price rises. That price rises higher if the supply is limited. Conversely, if no one’s interested in buying a stock, its price falls. Supply and demand is the nature of market risk. The price of the stock you purchase can rise and fall on the fickle whim of market demand.
Millions of investors buying and selling each minute of every trading day affect the share price of your stock. This fact makes it impossible to judge which way your stock will move tomorrow or next week. This unpredictability and seeming irrationality is why stocks aren’t appropriate for short-term financial growth.
Markets are volatile by nature; they go up and down, and investments need time to grow. Market volatility is an increasingly common condition that everyone has to live with (see the section “Getting the Scoop on Volatility” later in this chapter). Investors should be aware of the fact that stocks in general (especially in today’s marketplace) aren’t suitable for short-term (one year or less) goals (see Chapters 2 and 3 for more on short-term goals). Despite the fact that companies you’re invested in may be fundamentally sound, all stock prices are subject to the gyrations of the marketplace and need time to trend upward.
Investing requires diligent work and research before putting your money in quality investments with a long-term perspective. Speculating is attempting to make a relatively quick profit by monitoring the short-term price movements of a particular investment. Investors seek to minimize risk, whereas speculators don’t mind risk because it can also magnify profits. Speculating and investing have clear differences, but investors frequently become speculators and ultimately put themselves and their wealth at risk. Don’t go there!
Consider the married couple nearing retirement who decided to play with their money in an attempt to make their pending retirement more comfortable. They borrowed a sizable sum by tapping into their home equity to invest in the stock market. (Their home, which they had paid off, had enough equity to qualify for this loan.) What did they do with these funds? You guessed it; they invested in the high-flying stocks of the day, which were high-tech and Internet stocks. Within eight months, they lost almost all their money.
Understanding market risk is especially important for people who are tempted to put their nest eggs or emergency funds into volatile investments such as growth stocks (or mutual funds that invest in growth stocks or similar aggressive investment vehicles). Remember, you can lose everything.
Inflation is the artificial expansion of the quantity of money so that too much money is used in exchange for goods and services. To consumers, inflation shows up in the form of higher prices for goods and services. Inflation risk is also referred to as purchasing power risk. This term just means that your money doesn’t buy as much as it used to. For example, a dollar that bought you a sandwich in 1980 barely bought you a candy bar a few years later. For you, the investor, this risk means that the value of your investment (a stock that doesn’t appreciate much, for example) may not keep up with inflation.
Say that you have money in a bank savings account currently earning 4 percent (in 2016, the bank interest rate is much lower). This account has flexibility — if the market interest rate goes up, the rate you earn in your account goes up. Your account is safe from both financial risk and interest rate risk. But what if inflation is running at 5 percent? At that point you’re losing money. I touch on inflation in Chapter 15.
Taxes (such as income tax or capital gains tax) don’t affect your stock investment directly, but taxes can obviously affect how much of your money you get to keep. Because the entire point of stock investing is to build wealth, you need to understand that taxes take away a portion of the wealth that you’re trying to build. Taxes can be risky because if you make the wrong move with your stocks (selling them at the wrong time, for example), you can end up paying higher taxes than you need to. Because tax laws change so frequently, tax risk is part of the risk-versus-return equation, as well.
It pays to gain knowledge about how taxes can impact your wealth-building program before you make your investment decisions. Chapter 21 covers the impact of taxes in greater detail.
Political and governmental risk
If companies were fish, politics and government policies (such as taxes, laws, and regulations) would be the pond. In the same way that fish die in a toxic or polluted pond, politics and government policies can kill companies. Of course, if you own stock in a company exposed to political and governmental risks, you need to be aware of these risks. For some companies, a single new regulation or law is enough to send them into bankruptcy. For other companies, a new law can help them increase sales and profits.
What if you invest in companies or industries that become political targets? You may want to consider selling them (you can always buy them back later) or consider putting in stop-loss orders on the stock (see Chapter 17). For example, tobacco companies were the targets of political firestorms that battered their stock prices. Whether you agree or disagree with the political machinations of today is not the issue. As an investor, you have to ask yourself, “How do politics affect the market value and the current and future prospects of my chosen investment?” (Chapter 15 gives some insights on how politics can affect the stock market.)
Keep in mind that political risk doesn’t just mean in the good ol’ US of A; it can also mean international political risk. Many companies have operations across many countries, and geopolitical events can have a major impact on those companies exposed to risks ranging from governmental risks (such as in Venezuela in 2015) to war and unrest (as in the Middle East) to recessions and economic downturns in friendly countries (such as in Western Europe). Appendix A has resources to help with international investing.
If international investing interests you and you see it as a good way to be more diversified (beyond the U.S. stock market), then consider exchange-traded funds (ETFs) as a convenient way to do it. Find out more about international ETFs in Chapter 5.
Frequently, the risk involved with investing in the stock market isn’t directly related to the investment; rather, the risk is associated with the investor’s circumstances.
Suppose that investor Ralph puts $15,000 into a portfolio of common stocks. Imagine that the market experiences a drop in prices that week, and Ralph’s stocks drop to a market value of $14,000. Because stocks are good for the long term, this type of decrease usually isn’t an alarming incident. Odds are that this dip is temporary, especially if Ralph carefully chose high-quality companies. Incidentally, if a portfolio of high-quality stocks does experience a temporary drop in price, it can be a great opportunity to get more shares at a good price. (Chapter 17 covers orders you can place with your broker to help you do that.)
Over the long term, Ralph will probably see the value of his investment grow substantially. But what if Ralph experiences financial difficulty and needs quick cash during a period when his stocks are declining? He may have to sell his stock to get some money.
This problem occurs frequently for investors who don’t have an emergency fund to handle large, sudden expenses. You never know when your company may lay you off or when your basement may flood, leaving you with a huge repair bill. Car accidents, medical emergencies, and other unforeseen events are part of life’s bag of surprises — for anyone.
You probably won’t get much comfort from knowing that stock losses are tax-deductible — a loss is a loss (see Chapter 21 for more on taxes). However, you can avoid the kind of loss that results from prematurely having to sell your stocks if you maintain an emergency cash fund. A good place for your emergency cash fund is in either a bank savings account or a money market fund. Then you aren’t forced to prematurely liquidate your stock investments to pay emergency bills. (Chapter 2 provides more guidance on having liquid assets for emergencies.)
What does emotional risk have to do with stocks? Emotions are important risk considerations because investors are human beings. Logic and discipline are critical factors in investment success, but even the best investor can let emotions take over the reins of money management and cause loss. For stock investing, you’re likely to be sidetracked by three main emotions: greed, fear, and love. You need to understand your emotions and what kinds of risk they can expose you to. If you get too attached to a sinking stock, you don’t need a stock investing book — you need a therapist!
Paying the price for greed
In 1998–2000, millions of investors threw caution to the wind and chased highly dubious, risky dot-com stocks. The dollar signs popped up in their eyes (just like slot machines) when they saw that Easy Street was lined with dot-com stocks that were doubling and tripling in a very short time. Who cares about price/earnings (P/E) ratios when you can just buy stock, make a fortune, and get out with millions? (Of course, you care about making money with stocks, so you can flip to Chapter 11 and Appendix B to find out more about P/E ratios.)
Unfortunately, the lure of the easy buck can easily turn healthy attitudes about growing wealth into unhealthy greed that blinds investors and discards common sense. Avoid the temptation to invest for short-term gains in dubious hot stocks instead of doing your homework and buying stocks of solid companies with strong fundamentals and a long-term focus, as I explain in Part 3.
Recognizing the role of fear
Greed can be a problem, but fear is the other extreme. People who are fearful of loss frequently avoid suitable investments and end up settling for a low rate of return. If you have to succumb to one of these emotions, at least fear exposes you to less loss.
Also, keep in mind that fear is frequently a symptom of lack of knowledge about what’s going on. If you see your stocks falling and don’t understand why, fear will take over, and you may act irrationally. When stock investors are affected by fear, they tend to sell their stocks and head for the exits and the lifeboats. When an investor sees his stock go down 20 percent, what goes through his head? Experienced, knowledgeable investors realize that no bull market goes straight up. Even the strongest bull goes up in a zigzag fashion. Conversely, even bear markets don’t go straight down; they zigzag down. Out of fear, inexperienced investors sell good stocks when they see them go down temporarily (the correction), whereas experienced investors see that temporary downward move as a good buying opportunity to add to their positions.
Looking for love in all the wrong places
Stocks are dispassionate, inanimate vehicles, but people can look for love in the strangest places. Emotional risk occurs when investors fall in love with a stock and refuse to sell it, even when the stock is plummeting and shows all the symptoms of getting worse. Emotional risk also occurs when investors are drawn to bad investment choices just because they sound good, are popular, or are pushed by family or friends. Love and attachment are great in relationships with people but can be horrible with investments. To deal with this emotion, investors have to deploy techniques that take the emotion out. For example, you can use brokerage orders (such as trailing stops and limit orders; see Chapter 17), which can automatically trigger buy and sell transactions and leave out some of the agonizing. Hey, disciplined investing may just become your new passion!
INVESTMENT LESSONS FROM SEPTEMBER 11
September 11, 2001, was a horrific day that is burned in our minds and won’t be forgotten in our lifetime. The acts of terrorism that day took more than 3,000 lives and caused untold pain and grief. A much less important aftereffect was the hard lessons that investors learned that day. Terrorism reminds us that risk is more real than ever and that we should never let our guard down. What lessons can investors learn from the worst acts of terrorism to ever happen on U.S. soil? Here are a few pointers:
· Diversify your portfolio. Of course, the events of September 11 were certainly surreal and unexpected. But before the events occurred, investors should have made it a habit to assess their situations and see whether they had any vulnerability. Stock investors with no money outside the stock market are always more at risk. Keeping your portfolio diversified is a time-tested strategy that’s more relevant than ever before. (I discuss diversification later in this chapter.)
· Review and reallocate. September 11 triggered declines in the overall market, but specific industries, such as airlines and hotels, were hit particularly hard. In addition, some industries, such as defense and food, saw stock prices rise. Monitor your portfolio and ask yourself whether it’s overly reliant on or exposed to events in specific sectors. If so, reallocate your investments to decrease your risk exposure.
· Check for signs of trouble. Techniques such as trailing stops (which I explain in Chapter 17) come in very handy when your stocks plummet because of unexpected events. Even if you don’t use these techniques, you can make it a regular habit to check your stocks for signs of trouble, such as debts or P/E ratios that are too high. If you see signs of trouble, consider selling.
Getting the Scoop on Volatility
How often have you heard a financial guy on TV say, “Well, it looks like a volatile day as the markets plunge 700 points… .” Oh dear … pass me the antacid! Volatility has garnered a bad reputation because roller coasters and weak stomachs don’t mix — especially when your financial future seems to be acting like a kite in a tornado.
People may think of volatility as “risk on steroids,” but you need to understand what volatility actually is. Technically, it isn’t really good or bad (although it’s usually associated with bad movements in the marketplace). Volatility is the movement of an asset (or the entire market) very quickly down (or up) in price due to large selling (or buying) in a very short period of time.
Volatility tends to be more associated with the negative because of crowd psychology. People are more likely to act quickly (sell!) because of fear than because of other motivators (such as greed; see the earlier section “Emotional risk” for more info). More people are apt to run for the exits than they are to run to the entrance, so to speak.
Not all stocks are equal with regard to volatility. Some can be very volatile, whereas others can be quite stable. A good way to determine a stock’s volatility is to look at the beta of the stock. Beta is a statistical measure that attempts to give the investor a clue as to how volatile a stock may be. It’s determined by comparing the potential volatility of a particular stock to the market in general. The market (as represented by, say, the Standard & Poor’s 500) is assigned a beta of 1. Any stock with a beta greater than 1 is considered more volatile than the general stock market, whereas any stock with a beta of less than 1 is considered less volatile. If a stock has a beta of 1.5, for example, it’s considered 50 percent more volatile than the general market. Meanwhile, a stock with a beta of 0.85 is considered 15 percent less volatile than the general stock market. In other words, this stock would decline 8.5 percent if the market were to decline 10 percent.
Therefore, if you don’t want to keep gulping down more antacid, consider stocks that have a beta of less than 1. You can easily find the beta in the stock report pages that are usually provided by major financial websites such as Yahoo! Finance (finance.yahoo.com) and MarketWatch (www.marketwatch.com). (See Appendix A for more financial websites.)
WHY MORE VOLATILITY?
People will always gasp at the occasional big up or down day, but volatility is more prevalent overall today than, say, 10 or 20 years ago. Why is that? There are several contributing factors:
· First of all, today’s investor has the advantages of cheaper commissions and faster technology. Years ago, if an investor wanted to sell, she had to call the broker — usually during business hours. On top of that, the commission was usually $30 or higher. That discouraged a lot of rapid-fire trading. Today, trading is not only cheaper (with web-based discount brokers), but anyone can do it from home with a few clicks of a mouse on a website literally 24 hours a day, 7 days a week.
· In addition, large organizations — ranging from financial institutions to government-sponsored entities such as sovereign wealth funds — can make large trades or huge amounts of money either nationally or globally within split seconds. The rapid movement of large amounts of money both in and out of a stock or an entire market means that volatility is high and likely to be with us for a long time to come.
· Lastly, the world is now more of a global marketplace, and our markets react more to international events than in the past. With new technology and the Internet, news travels farther and faster than ever before.
Minimizing Your Risk
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.
Some people spend more time analyzing a restaurant menu to choose a $20 entrée than analyzing where to put their next $5,000. Lack of knowledge constitutes the greatest risk for new investors, so diminishing that risk starts with gaining knowledge. The more familiar you are with the stock market — how it works, factors that affect stock value, and so on — the better you can navigate around its pitfalls and maximize your profits. The same knowledge that enables you to grow your wealth also enables you to minimize your risk. Before you put your money anywhere, you want to know as much as you can. This book is a great place to start — check out Chapter 6 for a rundown of the kinds of information you want to know before you buy stocks, as well as the resources that can give you the information you need to invest successfully.
Staying out until you get a little practice
If you don’t understand stocks, don’t invest! Yeah, I know this book is about stock investing, and I think that some measure of stock investing is a good idea for most people. But that doesn’t mean you should be 100-percent invested 100 percent of the time. If you don’t understand a particular stock (or don’t understand stocks, period), stay away until you do. Instead, give yourself an imaginary sum of money, such as $100,000, give yourself reasons to invest, and just make believe (a practice called simulated stock investing). Pick a few stocks that you think will increase in value, track them for a while, and see how they perform. Begin to understand how the price of a stock goes up and down, and watch what happens to the stocks you choose when various events take place. As you find out more about stock investing, you get better at picking individual stocks, without risking — or losing — any money during your learning period.
A good place to do your imaginary investing is at a website such as Investopedia’s simulator (simulator.investopedia.com). You can design a stock portfolio and track its performance with thousands of other investors to see how well you do.
Putting your financial house in order
Advice on what to do before you invest could be a whole book all by itself. The bottom line is that you want to make sure that you are, first and foremost, financially secure before you take the plunge into the stock market. If you’re not sure about your financial security, look over your situation with a financial planner. (You can find more on financial planners in Appendix A.)
Before you buy your first stock, here are a few things you can do to get your finances in order:
· Have a cushion of money. 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, in case you suddenly need cash for an emergency (see Chapter 2 for details).
· Reduce your debt. Overindulging in debt was the worst personal economic problem for many Americans in the late 1990s, and this practice has continued in recent years. As of 2015, debt across the board has climbed to new all-time highs.
· Make sure that your job is as secure as you can make it. Are you keeping your skills up to date? Is the company you work for strong and growing? Is the industry that you work in strong and growing?
· Make sure that you have adequate insurance. You need enough insurance to cover your needs and those of your family in case of illness, death, disability, and so on.
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 in 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 in one type of investment. 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. By the way, I love ETFs and I think that every serious investor should consider them; see Chapter 5 for more information.
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. See Chapter 13 for more information about analyzing sectors and industries.
BETTER LUCK NEXT TIME!
A little knowledge can be very risky. Consider the true story of one “lucky” fellow who played the California lottery in 1987. He discovered that he had a winning ticket, with the first prize of $412,000. He immediately ordered a Porsche, booked a lavish trip to Hawaii for his family, and treated his wife and friends to a champagne dinner at a posh Hollywood restaurant. When he finally went to collect his prize, he found out that he had to share first prize with more than 9,000 other lottery players who also had the same winning numbers. His share of the prize was actually only $45! Hopefully, he invested that tidy sum based on his increased knowledge about risk. (That story always cracks me up.)
Weighing Risk against Return
How much risk is appropriate for you, and how do you handle it? 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: 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. Flip to Chapters 2 and 3 for details on determining your financial goals.
· 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.
· Asset allocation: I never tell retirees to put a large portion of their retirement money into a high-tech stock or other volatile investment. But if they still want to speculate, I don’t see a problem as long as they limit such investments to 5 percent of their total assets. As long as the bulk of their money is safe and sound in secure investments (such as U.S. Treasury bonds), I know I can sleep well (knowing that they can sleep well!).
Asset allocation beckons back to diversification, which I discuss earlier in this chapter. 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; see Chapter 1) 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.