A lesson in Risk Management in the Stock Market
1. An Introduction to Risk
In the Long Term, the stock market is the best performing Asset Class. But in the short term stock markets rise and fall, sometimes substantially. This short term volatility usually triggers two emotions:
- Fear
- Greed
It is important for you to master those two emotions (easier said than done!). The key to mastering your emotions in the stock market is to:
- Understand risk
- Learn how to measure risk
- Manage risk
The ‘word’ risk should not have a negative connotation. In fact, you should view it positively. Because it will stop you from looking at potential investments through ‘rose tinted’ glasses. ‘Confirmation bias’ is when you make your mind up about something and then look for any reason possible to prove you are correct even when you are wrong.
You need to get you into the habit of building an investment portfolio on ‘fact’ rather than ’emotion’. You will learn to avoid the most common mistakes made by retail investors including but not limited to:
- Buying stocks on a tip from a friend
- Not knowing anything about the stock you invest in
- Not having enough stocks in your portfolio
- Having the wrong types of stocks in your portfolio
Paying attention here could make and save you a lot of money in the future!
2. Diversify
Most important rule in the stock market: Diversify your risk.
Most retail investors do not have enough stocks in their portfolio. This exposes the retail investor to the ‘Unique Risks’ associated with those companies. Unique risks are risks that are specific to a particular company or industry that you invest in.
An example of ‘Unique’ Risk: Volkswagon
A great example of this in 2015 was the scandal with Volkswagon. No investor could have predicted that Volkswagon would be accused on tampering with emissions gauges on their engines. The stock dropped over 30% in 4 days! This is a clear example of unique risk.
Let’s pretend you invested all of your money in Volkswagon…. your portfolio would be down 30% in 4 days! Ouch!!!!
But don’t panic just yet…. what if you diversified your risk?
Diversifying your risk
Let’s imagine now that Volkswagon only accounted for 5% of our portfolio. In other words we only had 1/20th of our money invested in Volkswagon. What would this mean for us?
The answer is that the Volkswagon incident would have affected our portfolio by around 1.5% (30%/20). Now that’s a lot easier to handle, isn’t it?
Now imagine, that you had invested the rest of your cash in 19 other stocks. 5% into each stock. Many stocks went up whilst Volkswagon was falling so the profits from these would offset the losses in Volkswagon. This is called ‘Diversification’.
Key Lesson
Do not put all of your eggs in one basket! Read the next lesson to find out approximate allocation guidelines in each stock.
3. How to measure the risk of a stock?
At this stage you should know that you should only invest a small percentage into each stock. This helps reduce risk.
You should also know that you can increase or reduce risk even further again. Let us explain further…
A common measurement of risk in stocks is ‘Beta’.
What is Beta?
Beta is the sensitivity of a stock relative to the movement in a stock market index. The Beta of the stock market index is always 1. An example of an index is the S&P 500. The S&P 500 tracks the performance of the biggest 500 companies floated on the US stock markets.
Beta above 1:
If a stock has a Beta of above 1 it is said to be more volatile than that of the market. In other words it is ‘more’ risky. For example, Green Mountain Coffee (GMCR) has a beta of 1.72 (at time of writing). This means that if the S&P 500 moves up 10%, GMCR is likely to move up 10% * 1.72 = 17.2%. Conversely if the S&P 500 moves down 10% GMCR is likely to move down 17.2%
Beta Below 1:
If a stock has a Beta of below 1 it is said to be less volatile than that of the market. In short these are ‘less’ risky stocks. Take McDonalds for example (MCD), it has a Beta of 0.71 at time of writing. If the S&P 500 index moves up 10% MCD is likely to only move up 10%*.71 = 7.1%. Conversely if the S&P 500 moves down 10% MCD is likely to only move down 7.1%.
In summary, High Beta stocks are considered Higher Risk for Higher Reward. Lower Beta stocks are considered Less Risk for Less Reward.
Summary
The key to success in the stock market is learning how to understand risk and more importantly learning how to manage risk. You cannot eliminate all risk when you invest in the stock market. In order to make money you need to take on a certain amount of risk. But you can mitigate risk by taking some simple steps as outlined above.
Our Stock Market Courses will give you a step by step guide to building a successful investment portfolio.
Happy Investing
Stephen