Whether you're new to stock investing or a seasoned pro, one of the most important
aspects to consider is risk.
In this video, we'll discuss the risks associated with stocks and a few strategies investors
might use to help manage them.
One of the primary stock investing risks is market risk.
This risk stems from the correlated nature of the stock market.
Simply putóall stocks tend to move together, to some degree.
So, market risk is the risk that the overall stock market could trend lower, decreasing
the value of any stocks you own.
One way to monitor market risk is by watching the trend in a broad stock market index, such
as the S&P 500Æ.
Keeping an eye on the trend can help you make strategic decisions if the market seems to
be entering a new uptrend or downtrend.
For example, if the S&P 500 begins downtrending, some investors might reduce market risk by
selling stocks and moving proceeds into cash until the index starts a new uptrend.
In addition to market risk, stock investors need to consider sector risk.
This is the risk of bad news affecting an entire sector and impacting many of the companies
within that sector.
For example, suppose new legislation restricts energy consumption.
This news could hurt many businesses in the Energy sector, decreasing stock prices.
One way to help manage this risk is to diversify across a wide range of sectors.
This way, if bad news impacts one sector, only a portion of your stock investments would
suffer.
The last stock investing risk we'll discuss is business or company risk.
This risk encompasses all the risks that come with investing in an individual stock, such
as disappointing earnings or sales, a change in leadership, emerging competition, or new
regulations.
The most dangerous form of company risk is bankruptcy risk.
This is because if a company goes bankrupt, its stock will lose all its value.
One way to help manage company risk, including bankruptcy risk, is to carefully position
size.
A position size is the dollar amount invested in a stock relative to the size of your overall
portfolio.
For example, an investor might use a trading rule that prohibits her from investing more
than 5% of her portfolio in a single stock.
To give you an idea of what this looks like, let's assume this investor has a portfolio
of $100,000 and wants to invest in stock XYZ.
To manage her risk, this investor would limit her purchase to 5% of her entire portfolio,
or $5,000.
XYZ is trading at $50, so she can buy 100 shares.
Next, she uses stop orders on this position to potentially limit her losses.
Let's say she's willing to lose no more than 1% of her total portfolio, or $1,000,
on any one position.
She could set a stop at $40óthis is a loss of $10 per share or $1,000 for the whole position.
Ideally, if the position plummets, the stop order would trigger and likely help reduce
her losses to 1% of her portfolio, a relatively small and manageable setback.
Using strategies such as monitoring the trend of the broader stock market, diversifying
across sectors, and limiting position size are just a few ways to manage the risks of
stock investing.
But remember stocks are just one asset class investors can include in a portfolio.
One way to further manage your overall portfolio risk is to allocate investments across other
asset classes, such as bonds, commodities, and real estate.
This can help offset risks unique to stocks and potentially lead to more stable returns
in the long run.