This article is going to review some of the basics of investing. That review will start with a brief discussion of risk and return, and how these two factors should be the basis for most investment decisions.
Next, we'll talk about the types of risk that exist when investing in the stock market. Then we'll finish up with some suggestions that allow beginners to participate in the stock market while minimizing risk.
Balancing Risk and Reward
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Most beginners rightfully believe the stock market offers them a chance for higher returns on their investment. They think about moving their money from safer investments, such as money market accounts, into riskier securities, such as common stocks.
Recognizing the relationship between risk and reward is a good sign. There are winners and losers in the stock market every trading day. But the long-term rewards associated with the stock market are higher than safer investments such as bank accounts. The lesson here is simple: Greater investment rewards do come with greater risks.
Investing Risks
People take risks all the time, and most of these are "calculated" risks. A situation is carefully evaluated and a decision is made based on the assessment of the risks and rewards involved. Some risks can be controlled by the individual involved, while others are too large for just one person to control.
This same concept applies to the stock market and the common stock of companies. Generally, there are two types of risks an investor will encounter: market risk and individual company risk.
Market Risk
Everyone investing in the stock market is exposed to market risk. This is the large scale risk that the entire market either moves up or down. These movements may be due to external factors such as international political events or interest rates. There is very little an individual investor can do about market risk.
A refinement of market risk is industry risk, whereby all companies competing in a certain industry experience a downturn in their outlook. An investor has some control over this risk because they can steer clear of certain industries; especially if they are selecting individual stocks. Unfortunately, by selecting individual companies a second risk comes into play: The risk that the company selected will falter.
Individual Stock Risk
The good news is that investors can do something about the risk of an individual company. This risk can be mitigated by investing in a number of stocks, generally ten or more companies, thereby creating a portfolio and insulating the total investment from individual company risk. If one of the companies selected underperforms relative to expectations, there is a chance that another company will outperform expectations. Real estate is the most common long-term investment in America (45%), followed by equities and mutual funds (18%).
There are two ways to build a collection of stocks that can effectively lower an investment's exposure to individual stock risk. An individual can create a stock portfolio, or buy into one that has already been created. Both of these options offer diversification, and that lowers the overall investment risk.
Creating an Investment Portfolio
Most beginners do not have enough money to efficiently create a portfolio of stocks. It's also not a good idea for someone just starting out to create a portfolio. There is simply too much information to learn before taking such a big step.
Instead, beginners may be better served by purchasing a portfolio of stocks assembled by a professional, as can be done when buying shares in a mutual fund. Before getting into a discussion of mutual funds, a quick example will help explain why building a stock portfolio is expensive.
Stock Portfolio Example
It takes around ten different stocks to diversify away individual stock risk. In order to hold down transaction costs and fees associated with buying stocks, it's necessary to purchase around 100 shares of each company.
If the investing strategy is to purchase blue chip stocks like those appearing in the Dow Jones Industrials, each share of stock will cost the investor an average of around $35. Calculating the total cost of the portfolio:
10 companies x 100 shares of stock x $35 = $35,000
Clearly, $35,000 is a lot of money for a beginner to invest in the stock market. It's simply impractical to expect someone new to the process to put that much money at risk.
Mutual Funds
A more efficient investment approach is purchasing shares of a mutual fund, which offers investors several significant advantages including:
Diversification: a mutual fund is a portfolio of stocks, bonds, and other securities that are sliced thinly and sold to individual investors. With as little as $1,000 to invest, it's possible to buy a slice of a mutual fund.
Flexibility: investors can buy and sell fund shares over the Internet, by telephone, or even using the United States Postal Service.
Selection: an individual can choose from literally thousands of mutual funds, many tailored to the specific needs of certain investors.
Expert Management: most beginners are simply not equipped to forecast future earnings per share or prices of individual companies. A mutual fund pays a professional fund manager to perform this duty.
If an investor wants to enjoy higher returns, they need to take greater risks. While general economic conditions threaten all holders of common stock, there are some risks that can be controlled. Mutual funds provide investors with a great introduction to the stock and bond markets, while allowing them to leverage the expertise of the fund manager. Investors that want to learn more about mutual funds can explore specific topics, including buying an index fund, mutual fund loads, and our four-part series on buying mutual funds.
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