Hopefully you have finished reading part 1 of this article; The Pros and Cons of investing in the stock market to fund early retirement. If not, I implore you to go back and read it. Part 2 will focus on how to eliminate the disadvantages by actively managing the risk factors of stock market investing.
There is a certain level of risk inherent in stock market investing. There is no reward without risk. Certain risk management strategies can be employed to lower your chances of losing money. Those strategies include the following:
Diversification
In part 1 I used the example of Warren Buffet losing $4 billion in one day on one stock. (Apple) Had he not been diversified, this would have hurt him much more than it did. However, because he has a diversified portfolio of stocks, this was just another day of market fluctuation for him.
When considering a plan to diversify your portfolio, you can consider many factors. Below are a few of the most popular.
Industry type
It is important to diversify your stock portfolio over different industries. As in our example above with Buffet, it is not wise to invest on just one stock, It would also be just as unwise to stick to only one sector.
If all of your investments are in companies that reside in the technology sector, what happens if the technology sector crashes? You lose a a bunch of money. So the same as you would not put all your money in one company, you should not invest all of your money into companies of one sector.
Company Size
Another diversification strategy is to consider market cap. Market cap is a way of measuring a company’s net worth. It is the total number of outstanding shares multiplied by the current stock price. So as price goes, so goes market cap.
Companies are categorized in three ways; Large cap, mid cap and small cap.
- Large cap – $10 Billion or more
- Mid cap = $2 – $10 Billion
- Small Cap = less than $2 Billion
Large cap stocks tend to be safer investments but offer less in terms of growth. Conversely small cap are not as safe but typically have more growth potential.
By diversifying you can find a middle ground that allows you to be within your risk tolerance level while at the same time growing your portfolio at a steady rate.
Index Funds
Index funds are investment funds that attempt to duplicate the performance of a given index of stocks, for example the s&p 500. Index funds are a great way to invest in a large collection of well diversified stocks all at once. The best part of Index funds is that someone is doing all the work for you.
If you tried to re-create the dow jones you would need to figure out what specific portion of your total dollar amount you would spend on each of the stocks that make up the fund. Then you would need to consistently re-balance based on market fluctuations. It would be one big hassle. Or you could simply invest in an index fund that mimics the dow and use that time researching other investment options.
Do not try to time the market
One way to eliminate the urge to time the market is the cost averaging strategy. This strategy, also known as dollar cost averaging, involves purchasing fixed dollar amounts of your chosen investment at set intervals of time. So for example, buying $1000 every month of a particular index fund no matter what the price is. This strategy helps reduce the effect of volatility.
If you try to time the market, you may succeed from time to time but overall you will surely fail. Nobody can predict with certainty when stocks will rise and fall but if you take a more strategic approach you can ride the wave of long term steady gains by taking very little risk.
In short, stocks have many short term price fluctuations but deliver steady gains over the long term. Which is why you need to be in it long term.
Be a Long Term investor
The best way to reduce your risk when investing in the stock market is to be in it for the long haul. The odds of becoming rich overnight in the stock market are about the same as winning the lottery. It is a long term commitment.
The stock market has generally performed at between 7% and 10% over the last 100 years. The reason you want to assure you are diversified is so you can capture the general trend of the entire stock market. Eight percent is a terrific return but one that you will need to be patient to achieve. You will need to remain calm through bear markets, corrections and fluctuations. In the long run, you will be rewarded for your patience.
Here are some tips to help you devise a long term investment strategy.
Blue chip Companies
A Blue Chip Company is s company that has been well established, is financially sound and historically secure. These companies have a history of strong earnings and steady dividend payments. These are generally Large Cap stocks that have been around a long time.
Examples of blue chip stocks include Coca Cola, Disney, IBM, to name a few.
Take Coca Cola (KO) for example. You can be sure the company aint going anywhere. They have been around forever and pay a dividend of 3.5% or 40 cents per share per quarter. All of this plus the stock price doubled in the last 10 years. An average gain of 7% annually.
All you would have needed to do was be patient through the fluctuations and if you invested $10,000 in KO in 3/1/09 it would be worth about $20,000 today. If you reinvested the dividends back into the company, that total grows to just over $27,000. Almost 3 times your initial investment. And all you had to do was remain calm and patient over the long term.
Dividend Paying Stocks (DRIPS)
A dividend is simply a company paying out a portion of its profit to shareholder. Companies pay dividends either quarterly or monthly and are announced on a per share basis. For example, a company may announce that they will pay a quarterly dividend of $.50 cents per share every quarter. So if you own 100 shares, you would be paid $50 in dividends. This can be paid out directly to you or used to purchase more shares from the company.
A Dividend Reinvestment Program (DRIP) is a plan offered by a company that allows you to automatically reinvest your dividend payments into additional shares or fractional shares of a company in lieu of cash payments. This can be an extremely valuable tool for long term investors whose goal it is to maximize the compounding effect this has over time. DRIPS also allow for the purchase of fractional shares in the event the dividend payment does not cover the total cost of a share.
For more on dividends, check out this article.
Compounding
Being a long term investor, you are not in it for the quick gain. Your goal is to slowly but steadily grow your portfolio over time. The only way this works is through the compounding effect.
In its simplest form, compound interest can be defined as interest earned on interest. It is the result of re-investing interest paid on a principal so that the next period interest will be paid on the principal plus the interest that was previously earned. This goes on in perpetuity and has an exponential compounding effect.
For example, if your portfolio of $100 of stock gains 5% annually, it will total $105 after the first year. So, the $100 principal plus the $5 in gains. If the $5 in gains is re-invested, along with the original $100 and again earned 5%, the total at the end of year 2 would be $110.25. An so it goes year after year.
For a more in depth look at compounding, read this article.
Imagine doing this with your gains every year, and reinvesting all of your dividends using a dividend reinvestment program. You can see how your money will quickly begin its compound growth. Go back and look at our example of Coca Cola earlier. Had you invested in Coca Cola 10 years ago, never sold, and re-invested all of the dividends you would have nearly tripled your money.
Coca Cola: The quintessential long term investment
Coca Cola (KO) encompasses nearly all the principles at work here all rolled in to one company. They are a large cap blue chip company with more than 100 years of history behind them. They have offered steady gains year after year and have paid a quarterly dividend since 1920.
When it comes to long term investing, there is no better example of a company that provides steady gains at a minimized risk than Coca Cola. There is a reason Warren Buffet will never sell his stake in Coca Cola.
If you invested in a single share of Coca Cola in 1919 ($40 value) and reinvested the dividends, it would be worth over $10 million today.
Now before you run out and buy up a bunch of shares of KO, I am only using this as an example of what is possible. The most important factor involved in limiting your risk when investing in the stock market is…
Do you own research
Just because Coca Cola is the perfect investment for Warren Buffet does not mean it is right for you. Take the time to learn and do your own research before investing in any company. There are a million assholes like me out there who will try to give you advice, but the best advice I can give you is to not listen to our advice.
Spend some time understanding the company your are about to invest in. All stocks, no matter how safe, come with some risk. Make sure it fits within your risk tolerance level. I have myself made the mistake of losing my nerve on a stick I didn’t understand and I sold too soon causing myself to lose money. Conversely, I have also held on to stocks for too long and either failed to maximize my gains or held winners so long they became losers. This is because I failed to do the research to fully understated what I was investing in.
Learn what your risk tolerance level is, then make sure you understand what you are investing in and make a good educated decision. You make your money when you purchase the stock, not when you sell. What that means is that you should know going in what to expect and at what price you will sell and approximately how long it should take to get there. Failing to do this could cost you your hard earned money and shake your confidence in other investments you have made.
Stay steady an happy investing
Earl
Check out Part 1: The Pros and Cons of Investing in the Stock Market to Fund Early Retirement