Handling the Risks of Investing in Stocks: Part 2

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 discussed the risk of capital loss and volatility risk which come from investing in stocks, and ways to counter those risks.
  • In this part of the series, I’ll discuss valuation risk, the risk of market crashes, and individual risks.

Read part 1 of the article.

3. Valuation Risk

No matter investing for growth or income, overpaying for a company will not only reduce your returns but also increase your risk.

For example, during the internet bubble, Cisco Systems, Inc. (NASDAQ:CSCO) reached an all-time-high of $79. The price of buying at extreme overvaluation is an inevitable hard crash. To this day, it hasn’t come near that price.

graph showing Cisco's overvaluation in the internet bubble

Cisco was extremely overvalued in the internet bubble.

To counter valuation risk:

4. Risk of Unforeseen Market Crashes

Most people did not see the financial crisis coming in 2008-09. Other events that could cause market crashes include wars, epidemics, bursting of bubbles of sorts such as the internet bubble and the possible Canadian housing bubble.

To counter the risk of unforeseen market crashes:

  • Buy at reasonable valuations. Diversify your portfolio across sectors and companies with stable earnings. Sectors which come to mind include Consumer Staples and Utilities.
  • Set aside a cash position you’re comfortable with.
  • As a market crash is playing out, you’ll feel the pain. Remember not to panic and sell at a loss, but instead, put the cash position you might have set aside to work by averaging it into the top stocks on your watchlist.

5. Individual Risk: Know your own Temperament

Don’t let anyone else tell you how to invest. You don’t know which style of investing fits you until you try it. Try out various styles that you’re comfortable with and find out for yourself which fits you best! Perhaps, you’re a mixture.

To counter this individual risk:

  • Know yourself, and update your investing plan periodically according to what you learn.
  • Each time I buy or sell, I write down briefly the reasons why. For example, “adding to a core holding after a 10% pullback to fair valuation”, or “buying for a trade with an estimation of 10% to 20% gain in 6 months”.

6. Individual Risk: Unable to Manage Portfolio

We all need to plan for the unplanned. What happens when I become sick and need to stay in the hospital? What happens if I’m gone tomorrow? Who does the portfolio go to? Who has the ability or power to manage it?

To counter this individual risk:

  • Prepare for when you maybe unable to manage the portfolio yourself.

How are you handling your risks?

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Disclosure: At the time of writing, the author doesn’t hold any stocks mentioned in this article.

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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