New investors entering the stock market have a world of technical ratios and jargon to learn before fully understanding the underlying structure of equities, and even then, market movements often defy logic and burn even the most experienced investors. Some investors opt to purchase index or mutual funds to avoid the complexities of selecting individual stocks. Others may trust a financial advisor to do all the trading at a premium. However, if you are a younger investor with decades before retirement, trading stocks through a bare-bones electronic brokerage like E*Trade or Ameritrade can be a far more profitable and rewarding experience, provided that you understand risk management, and how to gauge the risk and volatility of individual securities.
All stocks are subject to two forms of risk – systematic and non-systematic.
Systematic risk is the risk that all publicly traded equities share due to market-wide movements. This is usually defined by macro-economic events, such as interest rate levels and political events. They can also be triggered through the domino effect of automated trades, as was seen in the “Flash Crash” of May 6, 2010, which dropped the Dow Jones Industrial Average nearly 1,000 points in a period of five minutes due to the cascading effect of computerized stops. Large mutual and hedge funds, which hold hundreds of securities simultaneously, also tend to buy and sell in massive volume based on macroeconomic events and can move the entire market. Systematic risk is often associated with the Wall Street proverb “a rising tide raises all boats”.
Non-systematic risk is based on the earnings strength of the underlying company of your stock and not the overall market. An example is a stock dropping on bad news regarding its quarterly earnings, executive shakeups or product recalls. In early 2011, the health of Apple CEO Steve Jobs and the succession plan of the company was a prime example of non-systematic risk. Non-systematic risk is generally more manageable than the systematic risk for the individual investor.
The traditional way of offsetting non-systematic risk is diversification across different sectors and asset classes. If you only buy one stock, and that stock is 100% of your portfolio, your emotions can easily force you to sell prematurely on any lulls in the price. However, if you set up a diversified portfolio by buying ten different stocks across different industries, such as energy, retail, technology, and food products, a drop in one company’s stock price can be offset by a rise in another. You can also diversify across different global regions, as domestic stagnation can be offset by growth in emerging markets and vice versa. This reduces the emotional aspect of investing and allows you to set a longer time frame for your investments and to outlast dips in the market to realize higher profits.
A diversified portfolio of 25-30 stocks has been mathematically shown to be the most cost-effective method of risk reduction, albeit with slower growth potential than a portfolio with more shares of fewer companies. In other words, a portfolio with fewer stocks will have higher volatility and growth potential, whereas one with more stocks will have lower volatility with limited growth potential. While diversification is a sound method of risk reduction, be wary of investing in more stocks than you can keep an eye on. Having too many stocks in your portfolio can also have the unintended effect of creating a personal mutual fund with a tight growth bottleneck. Creating a fully diversified portfolio can also be very expensive, and managed mutual funds, which offer instant diversification, maybe a better alternative for investors with limited budgets.
The beta coefficient of a stock is another important measure of risk. It is calculated in comparison to the broad market’s returns. The market is represented by a beta of 1.0 – a stock with a beta higher than 1.0 fluctuates more than the market, and a stock with a beta lower than 1.0 fluctuates less than the market. Stocks with a negative beta have returns moving in the opposite direction of the market, while a positive beta means the company’s returns follow the market’s returns.
The beta will give you an idea of expected volatility in the future – for example, an investor with a short investing time frame should not invest in a high beta stock because the wild fluctuations of the stock in the short term could force the investor to cash out at loss, but an investor with a longer investing time frame could benefit from a high beta because the volatile stock could make stronger gains in the long term than a low beta one. However, this also means that if a stock with a low beta declines significantly, it may take a longer time to increase in value than a high beta stock. In short, high beta stocks are riskier with higher returns, while low beta stocks are generally less volatile with lower returns.
Learning how to gauge the risks of an investment is the first and foremost rule of investing. Make sure you not only understand the mathematical risk of your investment but also the underlying business. Chasing a hot stock without a thorough understanding of these guidelines is reckless gambling, and not true investing.