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Tuesday, October 2, 2012

Managing Two Types of Risks in the Stock Market

One of the hardest challenges for investors in the stock market is managing risk.

There are at least two parts to managing risk.

1. The first part involves understanding what is a realistic potential reward for the amount of risk you are willing to take.

2. The second part is determining exactly how much risk you can tolerate and still be comfortable with investing.

Risk and reward go hand-in-hand, but they are not always balanced. For example, one stock may present a significant amount of risk, but given economic and market realities can only deliver a much smaller potential reward. In simple terms this means you will take way too much risk for far too little potential reward. Assessing potential reward involves understanding the company, its industry, the economy and market forces at play.

Even excellent companies face strong head winds when economic and market conditions are not in their favour. For example, a homebuilder, no matter how strong it might be in the market would've had a difficult time returning much of a reward to investors during the financial crisis that began in 2008.

It is not good enough to be a financially strong company if the economic and market cards are stacked against you. If you are a long-term investor and are very patient this kind of scenario may work to your benefit.

However, will only work if the price you pay for the stock is low enough so that any current reward is commensurate with the stock price and any future reward is predicated upon economic and market conditions changing to a more favourable position for the homebuilder.

Continuing our example, it would've been unrealistic to expect homebuilder to return 12 or 14% a year during the worst housing crisis in modern times.

If you are willing to wait for economic and market conditions to favor the real estate industry this company may have been made be a good long-term investment.

If the stock price was unrealistically high considering the conditions in the financial markets and the real estate industry, the stock may never achieve the kind of returns that most investors expect and need.

This is one of the prime reasons that when you evaluate a stock you examine not only the company but also its industry and how that industry fits into the economy and current business cycle.

One of the other ways long-term investors make money is by managing the level of risk so that they're comfortable with their investments.

Risk is a part of investing in stocks. You can't avoid the risk, but you can decide how much you are willing to take.

Not all stock investments are equal when it comes to risk. Smaller and newer companies are a greater risk than larger, more established companies are. Of course, in a severe down market, it may feel like every stock is in a free fall.

The question is how much risk are you willing to take?

In general, the higher the risk, the larger the potential reward should be. You should expect more conservative investments to produce lower returns.

The task for investors is to match their tolerance for risk with investments that will meet their financial goals.

But, how do you know how much risk you can tolerate?

A variety of "tests" on the Internet are available to measure risk tolerance.

We don't put much value in these tests. Here's why: When nothing is at stake, people tend to over-estimate their tolerance for risk.

A good analogy is playing poker for chips that you get for free contrasted with playing poker for real money. There is a significant difference in the way you play the game. When nothing is at risk, you may make wild bets and outrageous bluffs. However, when your actual money is on the table, most people will play much a much more conservative game.

Another way to think about risk is to consider this scenario:

If we offered you an investment and said, "there is an 80 percent chance this investment will be profitable," many people would say that's a reasonable expectation.

However, if we said, "there is a 20 percent chance this investment will lose money," many people would say that is too much risk.

Yet, it is exactly the same investment. The point is how you view your money and risk determines your risk tolerance. Most people know instinctively that some risks are too high, but not every investment presents an obvious risk you can gauge.

For most investors, finding their risk tolerance is a matter of experience. It is important that you avoid letting friends or your broker talk you into an investment that keeps you up at night.

You may need to adjust your financial goals to reflect a lower tolerance for risk, but keeping your risk at a comfortable will help keep you on track with an investment plan.