Taking Stock of Market Risks
It’s easy, given the seemingly unending fluctuations of the stock market, to forget that stocks have been a long-term certainty throughout market history. Yet even in perilous markets, investing isn’t the doomsday some perceive, provided you do your due diligence.
To be prepared for the risks of the stock market, you must understand what those risks are. Inflation risk occurs when the return on investment, or ROI, fails to outpace the inflation rate. Liquidity risk occurs when you are locked into an investment you are unable to sell. These risks make stocks a vital part of any diversified portfolio, given that the S&P 500 has traditionally outpaced inflation, and liquidity in the major markets, both domestic and abroad, is high.
That said, diversification won’t resolve problems on its own, nor will it make you impervious to market upheaval. It will, however, contribute to stability in choppy waters, should you keep some related tidbits in mind.
It’s human nature to try and time decisions by predicting trends. We’ve seen it with gas prices and housing prices over the years, but it’s been a constant among investors for ages. The simple reality history shows is that holding stocks for a longer period significantly trims an investor’s risk. Trust history, not your best guess.
Along that same line, trust, within reason, those companies that have performed historically well. Large companies are large for a reason: They’ve withstood the storms and they are the pacesetters, meaning they will be the first to reap the benefits of a rebound. While some huge public companies may fail, the overall strategy won’t.
Do not, however, confuse trusting the big names with limiting your portfolio. Rather, make those more secure stocks a component of a diverse portfolio that includes both domestic and foreign holdings, large and small, across industries.
Of course, perhaps the most important protection is understanding risk itself. For example, a stock that is selling for 60 times its earnings per share is far more risky than a stock selling for 10 times its earnings. Why? Because the former is considerably less likely to be able to maintain that pace. The former, a growth stock, should be complemented in your portfolio by value stocks.
The best protection, though not foolproof, if you fear declines is a stop order. This is an order to buy or sell a security once it reaches your designated price. So if you buy a stock at $20 a share and it reaches $40, you can set a stop at $30 to protect your $10 profit, though note some caveats. Market orders are taken in the order received, so those that come in before yours may greatly change your order’s execution price. Still, a stop order, or the more certain stop-limit order, is the best protection you can give yourself against not only loss but the fear of loss.
And emotion is half the battle of investing.
