Handling The Risks Of Investing In Stocks: Part 1

Summary

  • Buying stocks is a risk and reward game. We try to maximize the rewards and minimize the risks.
  • In the first part of the series, I’ll start by discussing the risk of capital loss and volatility risk which come from investing in stocks. And ways to counter those risks.

If I’m not better off investing in a stock, why bother the time, effort, and the cost of capital? I have the opportunity cost of not being able to use that money, while I’m holding that stock.

1. Risk of Capital Loss

Stocks on major exchanges can be bought and sold easily. However, the flip side of this liquidity is that it’s also very easy to sell at a loss. Some make a better investor in real estate because it is less liquid, even though one usually needs to get a mortgage to buy a house because the investment is much bigger.

When investing in a stock, there’s a chance that the company could go bankrupt. However, the odds are in the investor’s favor if he or she invests only in companies whose rewards outweigh the risks. So, the more likely scenario is to sell at a loss emotionally after the price of the stock goes down.

If that happens, then, you need to ask yourself why you sold at a loss. Did you no longer believe in the company you chose? Did something change from the story of when you made your purchase? Or was it due to emotion?

To counter the risk of capital loss:

  • Record why you bought the company in the first place.
  • If it’s for a short-term trade, decide the holding period and at what price range you plan to sell. Do that ahead of time without emotions.
  • Know thyself. That is, know your temperament, risk level, time horizon, experience, and test the waters if you have to.
  • Buy at reasonable valuations.
  • Have an investing plan and update the plan as you go.

2. Volatility Risk

A stock can go down (or go sideways) before going up again. For example, Microsoft Corporation (NASDAQ:MSFT) was at $49 in November 2014. Today, only a few months later, Microsoft is around $43, more than 12% dip.

Microsoft’s few months of action didn’t come close to the drama played out by the index. The SPDR S&P 500 ETF Trust (NYSEARCA:SPY) dropped from the $155 high in 2007 to the $69 low in 2009 to the current near all-time-high of $205. That is a 55% drop followed by almost 200% gain. And of course, in between the huge gain from 2009 to the present, there was volatility at smaller levels, dips of 7.5%, 10%, 12.5%, and the ever steady journey upwards — so far.

To counter volatility risk:

First, buy stocks at reasonable valuations, if not at a discount. Most importantly, invest for the long-term. The longer you stay in the market, the higher chance you’ll come out with positive returns. (If you invest in dividend stocks, you’ll get a positive return even in a down market, given the dividend is safe.)

Second, you can train yourself to ignore short-term ups and downs of a company. It’s common for companies to go up or down 1% to 3% in a day. During earnings report reason, it’s not uncommon for the company of question to go up or down 7-10%. Mentally prepare yourself for that.

So far, we’ve discussed a couple of risks in investing in stocks. More discussion on risks will be coming this week.

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Disclosure: At the time of writing, I am long NASDAQ:MSFT.

Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.

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