Diversify to Reduce Risk
Diversification to reduce risk should seem obvious to most investors but a surprising number of people follow their instinct rather than intellect when it comes to investing. Diversification is a simple concept: If you are shoe seller then you want to sell sandals and snowshoes to take advantage of sales in any season rather than putting all of your eggs in one basket. The same goes for stocks: diversification to reduce risk is easy once you conceptually understand that a limited amount of money is chasing the entire basket of available goods or services.
Diversification takes many forms: market capitalization, domestic vs. international, industry focus, etc. Also, asset allocation is a concept that involves several security types: stocks, bonds, cash. So, that's not applicable.
A solid diversification strategy is to invest in a diverse basket of stocks by focusing on various industry sectors, like: banking, consumer staples, technology, natural resources, health care, etc. If you buy 1 or 2 stocks in each industry, you'll manage risk better than buying stocks all from one industry or one country.
Manage Risk in Your Portfolio
Leverage, options and other types of speculation require one special talent, KISS: Keep It Simple Stupid. Sometimes the best advice is the hardest to follow especially for new investors hell-bent on making a killing on their first go. Use these tips to manage risk in your own portfolio:
- Set aside funds for other trades. Don't put all of your eggs in one basket.
- Sit some out. Don't chase every deal. Focus on what you know and understand.
- Diversify. Buy several stocks in several industries to spread your risk.
Measure Your Personality Risk
Risk is everywhere but there are some forms of risk that have no place in investing: personality risk is one of them. Are you your own worst investment adviser? Take a few minutes to determine how your personality might be placing you at greater than necessary risk in your investment decision-making process:
- Trusting and gullible. Failing to use critical analysis and common sense puts you at greater risk than you might think. Even if your stock broker has grown your portfolio the constant changes may have put more money in his pocket than your own.
- Careless and carefree. Manage your money like it means something to you. If you don't care about your profit and returns then how can you expect anyone else to? Know what you are buying, study the fundamentals and then allow others to carry out your instructions.
- Pride. Remember the old adage: pride comes before a fall. Don't become over confident to the point of relinquishing the sage advice and analysis that put you in this position.
- Greed. Mentally you know it's time to get out but you lack the discipline and willpower to make it happen by convincing yourself you are "on a roll" or "it's a sure thing".
- Fear. Are you a fearful person who always sees what can go wrong at the expense of seeing the potential opportunity to profit?
Discipline, hard work and information are the fundamentals to investment success that never go out of style.
Psychology of the Stock Market
Think twice before following advice from others: Doing what the majority does will lead to the same results derived by the majority of investors...poverty. Consider these startling statistics:
- The average person has less than $10,000 in savings.
- The average American is nearly broke by the time they reach retirement.
- The typical American household (40’s) has a retirement account of $18,750.
- The typical pre-retiree household (age 55 and up) has a retirement account of $60,000 for the household – usually two people.
- 51 percent of workers age 55 and older have saved less than $50,000 (not including the value of a primary residence).
- 39 percent of workers in the same age group have saved less than $25,000 in retirement savings.
- One in five or nearly 20 percent of pre-retirees age 50 to 64 has less than $5,000 in retirement savings.
Makes you want to re-think the investment savvy of the masses doesn't it? The psychology of the stock market is a powerful force. Who makes money? Those who understand their own risk-reward level and have an objective system in place rather than the "I can't stand it anymore" investment strategy. Take this quick quiz to see how you measure up:
- Have you determined your target rate of return required to meet your retirement objectives or are you banking on a quick killing?
- Do you have patience and discipline to remain objective when others are buying or selling based upon fear, greed or outright stupidity?
- Can you remain calm when others are making money and you aren't? How about when your portfolio is taking a temporary decline?
Psychology of the Stock Market: Perception
Personal perception is the most often cited measure used to make "sell" decisions by the uniformed and fearful. Don't let this happen to you! Here is a common example of how this plays out in "real life" situations. Stock market forums are terrific places to get a pulse on the current mindset of investors (just don't believe everything you hear); so while visiting our stock market forum you hear complaints about the price of the stock dropping with the subsequent moans, groans and theories as to the reasons behind the drop.
As an informed investor, your first question should be the price at which the stock was purchased. Frequently stocks are purchased by new investors during an upswing with a subsequent decline anticipated by all but the most novice investor. More than likely they heard the stock was hot and jumped in with the full expectation of the stock going up in value even further. Instead, the stock reached its resistance level and turned downward. No big surprise.
The same happens in reverse; new investors get frightened and begin selling right about the time the stock has reached its low and is positioned to turn around. Use stock market forums as your informal cue to read the psychology of the stock market and then act on information - not intuition.
Psychology of the Stock Market: Risk Aversion
You've heard of risk aversion but how does that affect the psychology of the stock market? For most people, the risk of losing is a bigger and more important threat than the potential reward of winning...a fact that can help a rational investor differentiate between real or perceived threat or opportunity. Use these basic insights into the psychology of the stock market to gauge the level of risk aversion at work:
- The majority of people focus on minimizing losses rather than optimizing gains.
- People tend to over-estimate both potential profit or losses depending upon majority consensus.
- Most people are more influenced by a 10 percent loss rather than a 10 percent increase.
- Given the choice, the majority of investors will forgo a higher rate of gain in return for safety or reduced risk.
- The majority of people will be more likely - not less likely - to rate a potential transaction less risky once they know others who have already participated.
Risk aversion is a perceptual problem that heavily influences the psychology of the stock market. It is based upon a poor understanding of probability. Take time to learn the fundamentals, invest in what you know and make decisions based upon knowledge and insight.
Resistance and Support Levels
Resistance and support levels are not the sole domain of the experts - in fact, if you plan to invest in the stock market then a basic understanding of technical analysis including resistance and support levels is essential.
Resistance can be thought of like a ceiling - it's the price at which buying stops and begins to track downward. Likewise, support can be thought of like a floor - the price at which buying begins to pick up as investors see a potential bargain. Over time, the price of stock will move toward one of these two levels indicating a high or low (sell or buy opportunity) for that specific stock.
Understanding the tendency to make several moves up before reaching a new high provides a basis for knowing when to buy, sell or hold. New investors typically over-estimate the momentum of a stock and tend to buy when the price of a stock is high and increasing with the expectation it will continue to increase. Suddenly, it drops and they are left wondering what went wrong. Nothing went "wrong" - it's a typical scenario repeated until a stock is able to break through a resistance level. To break through either resistance or support, there needs to be a significant change in the mass perception of the value of the stock. Once it breaks through, prices often move quickly.
Before buying on momentum or selling too soon, ask yourself the following:
- Do you understand the market drivers at work?
- Does the historical trend support the the projected model?
- Can you afford to be wrong?
- Who else agrees or disagrees?
- How accurate is your data?
Risk Adjusted Portfolios
Risk adjusted portfolios measure the rate of return after adjusting for risk. Let's begin by understanding risk as it relates to your personal investment profile. If you are close to retirement with a large nest egg just waiting to be spent on new golf clubs, travel and the occasional cigar then would it make sense to chase after huge returns if it put your entire retirement at risk? Of course not! Anyone with common sense would park the money in the safest place possible while generating a rate of return that out-paces inflation leaving a small amount for playing growth or other opportunities. The "risk free" rate derived from something like a government Treasury Bond establishes the comparison against which other forms of risk are measured.
On the other hand, if you are a twenty-something hoping Social Security will be around when you are ready for retirement at 68 (or 72) then parking your hard earned money in government savings bonds is akin to financial suicide. You need growth, not short term security at this stage in your life. On the other hand, let's face it, you probably don't have a lot to work with because you are still trying to pay off student loans and buy a house.
Use the Sharpe Ratio in conjunction with your risk adjusted portfolio analysis to create an entirely new way of looking at your rate of return versus risk. Your personal investing profile determines the level and types of risk appropriate for your portfolio - then it is time to decide upon the asset allocation levels based upon the premiums paid in return for the level of risk assumed. Unlike traditional buy and hold positions, a risk adjusted portfolio takes market conditions into account when determining asset allocation levels and types.
Survivor Portfolios are calculated with the Sharpe ratio
Risk Versus Reward: The Stock Market
Seeking an iron-clad way to manage risk? Keep looking. Rule number one of investing: If you can't handle the heat then get out of the kitchen. If you are risk aversive then your best bet is investing your money in government treasury bonds which offer a fixed rate of return. The stock market is volatile and risky by nature which is the very reason it generates greater returns than government bonds or bills. Investing in stocks can put your entire principle at risk and there are no guarantees - only the potential for profit.
On the other hand, in an attempt to manage risk, many people overlook one of the biggest potential threats to their investments: Inflation. Your principle may be safe when invested in savings bonds or Treasury bills but inflation slowly erodes the purchasing power of your investment. While your balance sheet shows growth, the reality is you have little more than you started with. Remember, the government inflation index doesn't account for many areas of day-to-day inflation that impacts your life such as groceries or insurance so your true purchasing power is decimated by a low rate of return. For example, yearly rates of return of Government bonds is 3 percent vs. the Stock market's 8 percent. To put it in perspective, compare these 1970's prices to what you pay for the same items today:
1970 Prices
- One Dozen Eggs: .59 cents
- 10 lb Bag Potatoes: .99 cents
- Loaf Bread: .37 cents
- New Car: $3,710
- House: $23,450
- Gasoline: .35 cents
To truly manage risk, compare the risk to the potential reward and then establish guidelines for investing that meet your need for growth versus safety.
Risky Business
One of the biggest signs of a green investor is taking on too much risk. You might as well hang a sign around your neck that says "kick me". So, what are the tell tale signs of a completely green newbie?
According to research conducted at Harvard, those with the least amount of money have a tendency to take on more than their share of risk while those with the most amount of money err on the side of caution (perhaps one reason they have more money to begin with!).
Other signs that scream "Newbie" include:
- Selling winners while holding on to losers hoping that the losers will one day turn profitable. The rule to live by? sell your losers (15% loss or more) and let your winners run.
- Unwillingness to take a loss. Know when to sell and cut your losses. The first few times are the hardest but it's part of playing the game.
- Frequent trading. Beside making your broker happy those transaction fees are eating away at earnings. Have a system and stick to it.
- Expecting the "big quick fix".
Remember, jackpots happen but not to crackpots.
Sharpe Ratio Explained
The Sharpe Ratio, named after Nobel laureate William F. Sharpe, measures the rate of return in association with the level of risk used to obtain that rate. It's a particularly useful tool for novice investors to use as a method tracking "luck" versus "smarts".
Here's an easy example to help conceptualize how the Sharpe Ratio works in real life. You and your two friends are out for a drink when the topic turns to investing. Friend number one is the play it safe guy who puts his money in Treasury Bonds and hopes for the best. Essentially his investment is as close to risk free as possible (excluding the threat of inflation of course). It's safe and requires nothing more than automatic payroll deductions to generate a steady - albeit decidedly insignificant - rate of return.
This is considered a "risk free" rate. Since anyone can obtain that rate of return by doing almost nothing, it is removed from the equation. Stocks, by their very nature, have some element of risk and as a rule of thumb, any investment with an element of risk should generate a premium above the risk free level...otherwise, why put your money at stake?
Friend number two is telling you about his hot new investment tip that just generated an amazing 25 percent rate or return. Is this guy a genius or what? Maybe not. By using the Sharpe Ratio, you can measure whether your friend is taking on too much risk. Briefly, it works like this...
Subtract the risk free rate (like that available from your friends Treasury bills) from the rate of return generated then divide by the standard deviation of the portfolio returns. The result provides a way to measure the excess return derived from the level of risk assumed...not necessarily insight and intuition. Chances are your friend isn't a genius but rather a lucky hot-shot who needs to take the money and run before his luck runs out.
One final note: if your investment portfolio isn't performing above the risk free rate then it's time to put up or shut up. Either figure out what you are doing wrong and begin educating yourself on the basics of investing or sign up for those bonds via payroll deduction and hope inflation leaves you a little to live on by retirement.
Stock Market Forum Tips: A Fools Game
A stock market forum is there to provide feedback but only a fool would trust the so-called insight as reason enough to make an investment decision. Stock market forums are notoriously easy to manipulate due to the psychology of the stock market. The tendency of people to do what others are doing - following the crowd so to speak - has a limit when it comes to investing.
A stock market forum tip is nothing more than a shot in the dark. What is the motive of the message? What are the credentials of the person providing the tip? Most importantly, how useful is a message that thousands - if not millions - of others will soon rush to implement? Hot tips might be a great way to unload a dog on unsuspecting fools but don't believe everything you read on a stock market forum. Instead, stick to what you know and buy value based upon the fundamentals. Better yet, use stock market forum tips to your advantage by positioning yourself as a contrarian investor in order to benefit from the madness of crowds.
Use these tips to take full advantage of any stock market forum:
- Think for yourself. Buy what you know and understand your exit strategy.
- Don't settle for pat answers or "common wisdom".
- Challenge convention and be skeptical of experts.
- Steer clear of fads.
- Control your emotions.
Participate in the Wall Street Survivor Forums
Using Options to Reduce Risk
Many people have never considered using options to reduce risk because they have been told options are dangerous or risky. Like most financial advice, take a look at the source before you believe it hook, line and sinker. Unless your source retired thanks to his stock portfolio before the age of thirty then stop believing everything you hear and begin thinking for yourself.
Put options are one method of minimizing your exposure to risk - particularly if you are holding significant equity in only a few stocks (if that is you, then be sure to read our tips on diversification to reduce debt). By putting all of your eggs - or stocks - in one basket, you are opening yourself up for heavy potential losses should a problem arise. The biggest culprits are usually employees who believe their company is rock solid - take a moment to think this through. First of all, a lot of Enron employees thought the same thing but where are they today? Next, you are at double exposure to risk - the loss of your job combined with the loss of your investment portfolio!
So, ready to hear how those put options work in real life? It's simple really...a put option requires you to pay an up-front premium for the "option" of selling your stock at a specific price within some period of time. Let's assume you work for company XYZ and have invested heavily in the purchase of company stock. You don't want to take a heavy tax hit by selling your stock this year, so you aren't quite prepared to take the good advice to diversify in order to reduce your risk but you are not completely without prudence, and decide to explore the use of put options instead. Good decision.
Let's assume XYZ is selling for $35 per share and you want the ability to sell at $30 a share for the next year at which point you will be in a better position to diversify your portfolio. For now, you decide to pay $2 a share to buy a "put option". The $30 per share is called your "strike price". If the stocks go up - great! Do nothing. If the stock drops like lead (or Enron) then your put option allows you to sell your shares for $30 each no matter how low they go on the market.