Managing Stock Risk

When it comes right down to it, the greater returns on investment that are associated with the stock market are related to the market's risk.  Investing in common stock is riskier than putting your money in a savings account.  Fortunately there are a couple of steps an investor can take to minimize that risk.

The stock market is a very efficient marketplace and the forces of risk and reward are constantly in motion.  In this article we're going to explain some of the techniques used to reduce that risk.  That discussion will include a brief description of the risks involved with the stock market as well as some of the simple measures you can take to lower that risk.

Stock Market Risk

We take a lot of risks every day, but here we're going to discuss two kinds of stock risk you can control:

• Individual Stock Risk
• Marketing Timing

Individual Stock Risk

When you buy a stock in a company, you expect that company provide you with a return on your investment.  But you're buying a part of a real company and that company can perform better or worse than expected for a variety of reasons.

This is what we mean when we're talking 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 take off.

When you buy an individual stock, you're investing in a single company and the management of that company can make good or bad decisions and consumers can buy more or less of their products and services.  That's a risk you're taking when you own their stock.

Timing the Market

Another risk that buyers of common stock assume has to do with market timing.  For example, you might buy a stock at the peak of an upswing in 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 affects associated with buying stocks.  For example, the stock market itself could be at the end of a bull market and the entire market is about to experience a cyclical downturn.  On the other hand an individual stock might have reached its peak and is about to start a decline.

The problem is an investor can never be too sure if a bull market has run its course of if it's going to continue for several more years.  The same hold 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.

In this example, the risk that that investor wants to protect themselves against is a downturn in prices.  And that last point brings us back to what this article is all about - how to manage stock risk.

Controlling Stock Risk

There are three strategies that investors can leverage to help insulate themselves against the two types of risks just discussed:

• Own a Portfolio of Stocks
• Invest Over Time
• Hold Stocks Long-Term

The first strategy - owning a portfolio of stocks - can help reduce or minimize individual stock risk.  The next two strategies help investors overcome the "time the market" risk.

Creating Stock Portfolios to Reduce Risk

First off, our assumption is that you've thoroughly researched your stock purchase and you've made what you feel 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 to diversify away that risk by owning share of stock in more than one company.

For example, let's say that you have $100,000 that you want to invest in the stock market.  With that money you could create the following hypothetical stock portfolios:

Stock Portfolio 1

Stock Portfolio 2

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.  You've got all your "eggs in one basket" so if the price of Google goes down, so does the value of your entire investment.

The second stock portfolio diversifies away the risk associated with an individual company under-performing because you own stocks in five different companies.  You're managing 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 - you lower the overall risk of your entire investment.

Investing Over Time

A second strategy investors can adopt to help manage stock risk is to invest their money over time.  By investing over time an investor can lower the risk associated with timing the market.  The most common way to invest over time is a technique referred to as dollar-cost averaging. 

Dollar-Cost Averaging

With dollar-cost averaging the investor contributes a fixed amount of money into the stock market at regular intervals.  For example, you might contribute $200 each week from your paycheck into a 401k plan that ultimately buys shares of stock in a mutual fund or shares of stock in the company you work for, or even a DRIP.

Over the loan haul, dollar-cost averaging can lower the average cost of the shares you own.  This happens because the fixed amount you're contributing each week buys more shares when prices are lower than when they are higher.

Long Term Investing Horizon

The third, and final, technique we're going to discuss for controlling risk has to do with your investment timeline.  This is a second strategy you can use 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 that the stock market is subject to short-term fluctuations and even longer term bear markets.  But over the long-term the stock market had traditionally strong performance in terms of return on investment.  For example, the S&P 500 - a widely accepted indicator of overall market performance - provided an average annual return in excess of 9% in the ten years from 1995 through 2006.

And while past performance is certainly no guarantee of future performance, by adopting a long-term investment planning horizon you can minimize the risk of relatively short-term market downturns.

About the Author - Managing Stock Risk

Copyright © 2007 Money-Zine.com

Stock Market Resources on the Web