If you’re someone who’s just about begun investing in stocks, then you know better than most, how difficult it can be to actually make money from your investments. An overwhelming multitude of numbers, ratios, and charts threaten to wreak havoc on your unprepared mind. But you put up your bravest front, and unflinching, get down to work.
Equity Investing 101
Profit, loss, and risk—even though all of us learnt these 3 simple word as kids, we need to carefully reconsider them as investors. Of these 3 investment mandates, risk is undoubtedly the most-ignored one.
Multiple facets of risk need to be taken into consideration before making an equity investment. Below, we’ll be looking into the significance of risk management in equity investing.
How Risk Can Squash Equity
While trying to comprehend equity risk, you need to consider both macroeconomic and microeconomic factors. Macroeconomic risks, present in the form of interest rates, CD rates, currency value, inflation rate, central bank policies, etc., constantly assail equity investors.
Corporate performance risks, on the other hand, are the microeconomic factors that affect a particular stock. When you buy a stock, you buy a part of a publicly-listed firm. You should know that a company’s performance on the stock market is heavily influenced by its quarterly earnings. If a firm fails to meet the consensus market expectations for a particular quarter, it is inevitably punished on the stock market.
Before making an investment, you need to thoroughly examine a company’s fundamentals; this includes delving into details like consumer preferences, operating costs, cash flow, and so on. You also need to learn how to read a balance sheet effectively.
And if overseas securities are part of your portfolio, you have more potential trouble. Stocks whose prices are denominated in foreign currencies become exposed to the risk of currency movement. Due to the volatile nature of the stock market, you can never be completely sure of your investment prospects.
When you take such factors into consideration, you slowly begin to understand how your stocks are always in peril. So, how do you tackle these dangers and make successful investments? One word says it all—diversification.
Simply put, when you invest in multiple stocks across a range of sectors and market caps, you end up minimizing your overall investment risk; this is similar to investing in an equity fund. Sure, you can create a diversified equity portfolio and minimize your chances of loss, but is that all there is to effective risk management?
Well, not really.
In order to successfully mitigate your equity risk, you first need to understand the value of investing in multiple asset classes.
Asset Classes to the Rescue
Assets can be broadly classified into 3 types—equities (stocks), fixed-income securities (bonds), and money market securities (cash equivalents). Any seasoned investor will tell you that real diversification means balancing your investments carefully over different asset classes. Some consider the real estate market to be an asset class as well. But regardless of the lineup, each class provides it own set of risks and returns, offering a unique environment to invest in.
From this expansive viewpoint, we can see that an ideal investment portfolio is one which covers all asset classes. That is to say, if you use the right investment strategy, you won’t go bust even if both the stock market and the real estate market crash. And if all hell does break loose, you know you can always depend on those trusty government bonds you’ve been saving up on.
But, how do you do it? Well, let’s find out.
Learn To Balance Your Portfolio
In order to stay on top of your equity investments, it’s imperative that you appropriately balance your portfolio.
So what happens when you ignore asset allocation? Say you’ve set aside $10,000 for your investments. You decide to buy $4000 in equities, $4500 in regular bonds, and the rest in treasury bonds. After a year, you find out that your $4000 investment in equities has now become $5000—signifying a whopping 25% increase. On the other hand, your regular bond fund suffered slightly, shrinking to $4000 in value, while the Treasury bond fund showed a modest appreciation of 3%.
Spurred by the excellent performance of your equity fund, you increase the size of your equity investment from $5000 to $6000, while decreasing your investment in bonds and maintaining your investment in treasury bonds. However, by next year, you find out that your equity fund took a hard hit in a bear market, reducing to $3000 in value. Your bond fund, on the other hand, declined by just 3%—and this is around the time most people realize the gravity of investing in equities.
When measured over a 10-year period till 2012, it was found out that treasury bonds outperformed equities. The vast majority of the American public, however, remains fixated with the stock market—partly due to the above-par performance of equities in the latter part of the 20th century. While government-bonds returns were hit hard in the 60s and 70s, the equities sector benefited largely from the lack of wars and financial depression.
Granted, equities offer amazing investment prospects that other assets may not. But that does not give you the excuse to overindulge in the stock market. Be sure to thoroughly gauge the prevailing market conditions to allocate your assets in the best way possible.
When it comes effective risk management, this quote from Warren Buffett pretty much sums it up, “Never test the depth of the river with both your feet.”