Is investing in the stock market risky? You bet it is!
You can lose all the money you invest, for one thing. In fact, invest in some super-risky ways and you can even lose more than you invested! Yikes!
But wait -- it's not all so bad. There are lots of ways that you can reduce the risk you face in investing. Permit me to review some of them.
Stick with what you know
Are you excited about a supposedly promising gold mine in Tunisia that a friend recommended to you? Are you thinking of investing in a biotechnology firm that's seeking a cure for cancer? Think again. Unless you're very familiar with these fields, you should probably avoid them.
I screwed up many times in my own investing by plunking money into companies I didn't understand very well, such as Sun Microsystems (NASDAQ:SUNW). I'm not much of a technology follower and couldn't have explained to you all the things Sun made and why it was better positioned than its competitors. But I've since tried to change my ways. I'm now focusing on companies I know a lot better, such as PepsiCo (NYSE:PEP), the Washington Post Co. (NYSE:WPO), and Home Depot (NYSE:HD). I'm familiar with PepsiCo's products -- which include the brand names Pepsi, Frito-Lay, Tropicana, Gatorade, and Quaker. I have an understanding of the Washington Post's position in the newspaper world and appreciate the power of its Kaplan educational division. I shop at Home Depot (and Lowe's) frequently and can see how prices change and how busy the stores are.
Diversify, but not too much
Are you invested mostly in the stock of your employer? If so, you've put yourself at considerable risk. Maybe your firm looks nothing like Enron, but even well-regarded firms can see their stocks sink or languish. Think of General Motors (NYSE:GM), Eastman Kodak (NYSE:EK), and Pfizer (NYSE:PFE), for example. I myself own shares of Pfizer and plan to hang on for the long haul, but I've been in the red on it for quite a while.
Aim to hold stock in perhaps eight to 15 companies. More than that is often problematic, as it can be hard to follow them all. If you're not comfortable picking your own stocks, look for some outstanding mutual funds, such as a simple index fund or some of the standouts recommended in our Champion Fundsnewsletter.
Have realistic expectations
If you know what to expect from your investments, you're less likely to be surprised, panic, and make rash mistakes.
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Expect to lose money now and then. It happens to the best investors on occasion. Stock investing will never be risk-free.
- Don't expect to earn 20% or 30% each year. Know that the stock market's long-term average is more like 10% per year, and during the long period you're invested, your own annual average might be 8% or 12%.
- Be patient. Great wealth through the stock market is usually built slowly, over many years.
Avoid extra-risky kinds of investments
Some ways of investing are much riskier than others. Here are a few, which you should consider avoiding (you'll find another overview of them in step 12 of our "13 Steps to Investing Foolishly"):
Day trading. A study by the North American Securities Administrators Association a few years ago suggested that only about 11.5% of day-traders might trade profitably. (Of course, trading "profitably" does not even mean that they will beat the S&P 500, which anyone can do at a very low cost via the purchase of an index fund.) According to managers of day-trading firms cited in a Washington Post Magazine article, about 90% of day traders "are washed up within three months." David Shellenberger of the Massachusetts Securities Division has noted that "Most traders will lose all of their money." A principal of a day-trading firm even admitted that "95% [of day traders] will fail in the first two years."
Be a long-term investor, not a day trader. Holding a stock for only a few weeks, days, or hours is not investing -- it's gambling. Real investors think of themselves as committed part-owners of businesses. Convinced of a company's value, they plan to hang on for quite a while, often years. The longer your investing horizon, the more likely the stock market is to rise, and the less risk there is of losing money. In the short-term, anything can happen -- including crashes. One or all of your holdings could fall by 20% tomorrow. If you're holding on for years, you can ride out downturns. If you plan to sell in 15 or 20 years, what happens this year isn't a big risk to you.
Technical analysis. Here's how Bill Mann described this approach: "Technical analysts ... believe that the stock market is a story of supply and demand; that price trends and chart formations can tell a trader what a stock or other security is likely to do next. They follow trends; they speak a language of formations and patterns. There are some who utilize both technical analysis and fundamental analysis, but for many, it's nothing short of a religious war. To fundamental investors, technical analysis is soothsaying. To technical traders, fundamentalists are the slow-footed oafs who don't know what's happening until it's already happened, at which time the traders are long gone."
Options. These can be used in aggressive and less aggressive ways. It can be instructive to learn how options work -- just don't use them until you know what you're doing, if you use them at all. Some Fool articles on the topic:
- Options Explained
- Bullish Options Strategies
- Bearish Options Strategies
- Considering Stock Options
- Leverage Is Speculation Defined
Margin. Buying stock on margin involves borrowing funds from your brokerage, which charges you interest for the privilege. Doing so gives you leverage to enhance your profits -- or losses. Learn more in this FAQ on margin. And in these articles:
Shorting. You may not realize it, but you can make money when stocks fall in price through shorting. Learn more in these articles:
- Shorting Stocks FAQ
- The Art of Shorting
- Is Shorting Stocks Foolish?
- The Long and the Short of It
- Coming Up Short
- Respect Shorts
Penny Stocks. Penny stocks are those trading for less than about $5 per share, and they're extra risky because they can be extremely volatile and easily manipulated. They're the playground of many charlatans. Learn more in these articles:
- Congressional Testimony of Tom Gardner
- Securities Fraud: Penny Stocks
- Hype, Spam, and Penny Stocks
- Penny Stock Nation
Be sensible, and look for value
Too often, investors focus on a stock's story or price and fail to see the big picture. Limit your downside. Read up on the risks companies disclose in their financial statements. Consider valuation. A company that seems undervalued (according to measures such as market capitalization, price-to-sales and price-to-earnings ratios, and expected future earnings) should offer less downside risk than an exciting high-flier. You can do well with some high-fliers; just understand that they're riskier. (Learn more about valuation.)
Know what you're doing -- keep learning
Increase your knowledge. The more you know, the less chance you have of making mistakes. Too many people buy companies merely on "hot" stock tips from friends or strangers. Sometimes they don't even know what the company does.
Learn about investing. Read all you can. Start with books by Peter Lynch. Read Berkshire Hathaway (NYSE:BRKa) (NYSE:BRKb) Chairman Warren Buffett's letters to shareholders, which are written very clearly and impart much wisdom. Hang out at the Fool online, reading and asking questions. Invest only in companies you know and understand well, ideally companies whose products or services you use yourself. Here's a long list of recommended financial books. By reducing the risks you take in investing, you should increase your chances of doing very well.
Selena Maranjian 's favorite discussion boards include Book Club , Eclectic Library, and Card & Board Games. She owns shares of PepsiCo, Washington Post, Home Depot, and Pfizer. For more about Selena, view her bio and her profile. The Motley Fool is Fools writing for Fools.
