The greater returns associated with the stock market are directly related to the market's risk. Given the choice between investing in common stock or placing money in a savings account at a local banking institution, the investor should expect higher returns if they choose stocks.
Fortunately, there are steps an investor can take to lower the risks associated with buying shares of stock in a company. In this article, we're going to explain the different types of risks associated with the stock market, in addition to the steps that can be taken to lower each risk.
There are two categories of risks associated with the stock market that can be controlled:
This is what is meant when experts talk about individual stock risk. A new competitor could enter the marketplace, and put downward pressure on prices. Or a company's research department could develop a new widget that causes sales to increase rapidly.
When buying an individual stock, it's an investment in a single company. The management of that company can make good or bad decisions, and consumers can buy more or less of their products and services.
Another risk that buyers of common stock assume has to do with market timing. For example, an investor might buy a stock at the peak of an upswing in its price. In fact, many times this fear of "buying high and selling low" keeps investors away from the market.
With this type of risk, we're talking about both macro and micro effects associated with buying stocks. For example, a bull market could be coming to an end, and the entire market might experience a cyclical downturn. On the other hand, an individual stock might have reached its earnings peak, and is about to start a decline.
An investor can never be certain if a bull market has run its course or if it's going to continue for several more years. The same holds true for a company's stock. While the stock price might be at an all time high, that doesn't necessarily mean it's not going higher.
There are three strategies that investors can leverage to help insulate themselves against the two types of risks just discussed:
The first strategy, owning a portfolio of stocks, is effective in reducing or minimizing individual stock risk. The next two strategies help investors overcome the "time the market" threat.
Our assumption is the investor has thoroughly researched the stock purchase, and they've made what they believe is a good investment decision based on the information available on a particular company. If that's true, then the most common strategy adopted by investors to reduce the risk associated with an individual stock is diversification. The risk associated with owning shares of stock can be reduced by investing in more than one company.
For example, let's say Joan has $100,000 that she wants to invest in the stock market. With that money, she could create the following hypothetical stock portfolios:
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Both of these stock portfolios carry with them risk that an individual company might under-perform versus the market's expectations, and their price per share will drop. But the first portfolio carries with it much more risk. Joan has all her "eggs in one basket," so if the price of Google goes down, so does the value of her entire investment.
The second stock portfolio diversifies away the risk associated with an individual company under-performing because it contains the stocks of five different companies. This is how investors are able to manage stock risk; through the creation of a diversified portfolio of stocks. Coca Cola might under-perform, but General Electric might over-perform. By owning a portfolio of stocks, which is a very good reason to buy shares in mutual funds, it's possible to lower the overall risk of the entire investment portfolio.
A second strategy investors can adopt to help manage stock risk is to invest their money over time. By investing over time, it's possible to lower the risk associated with timing the market. A technique known as dollar-cost averaging is the most common way to invest over time.
With dollar-cost averaging, the investor contributes a fixed amount of money into the stock market at regular intervals. For example, Sally might contribute $200 each week from her paycheck into a 401(k) plan, which ultimately buys shares of stock in a mutual fund, shares of stock in the employee's company, or even a DRIP.
Over time, dollar-cost averaging can lower the average cost of the shares she owns. This happens because the fixed amount she's contributing each week buys more shares when prices are lower than when they are higher.
The third, and final, technique we're going to discuss for controlling risk has to do with the investment timeline. This is a second strategy that can be used to help lower the risk associated with timing the market. The last thing any investor wants to do is buy high and then be forced to sell low.
There is no doubt the stock market is subject to short-term fluctuations, and even longer-term bear markets. But over the long haul, the stock market has traditionally turned in a strong performance in terms of return on investment. For example, the S&P 500 Index, a widely accepted indicator of the overall market performance, provided an average annual return in excess of 13.5% in the ten years from January 2010 through January 2020.
While past performance is certainly no guarantee of future returns, by adopting a long-term investment planning horizon, it's possible to minimize the risk of relatively short-term market downturns.
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