In one of our earlier articles we have discussed major types of risk stock investors should know while investing. You need to know your comfort level of taking risks. Accordingly, you need to formulate your own investing style and strategy to minimize or manage risks.
Knowing the risk-return trade off is the most important step towards stock market investing.
Remember, you should not be afraid of these risks. You should know how to manage and minimize its impact on you.
In this article, we will tell you how to manage risks in the stock market to maximize your return.
Know your risk taking capacity
Before investing in stocks, the first step is to measure and determine your risk tolerance. By knowing your level of tolerance, you can choose different stocks and/or other financial assets suitable for your financial goals.
You might have heard the direct correlation between risk and return. Which means, the greater the risk, the greater the potential return to entice investors. However, without proper planning to manage risks and return, you will not be able to succeed in the stock market.
Remember, understanding your risk taking capability is the first step towards stock market investing.
If you are a nervous person who cannot sleep well at night when the stock price falls below the buying price, then you are a low risk taker or a conservative investor. In such a case, you need to have a conservative approach towards investing by selecting risk free investments, defensive and blue-chip stocks which are very less risky.
Following example might help you to assess your own investment style based on risks.
Immagine you have invested the entire money as planned in 10 to 15 stocks. After investing, the stock market started falling due to certain market uncertainty. It fell by 20-30% in 6 to 7 months. What would you do?
- If you do nothing, you are an aggressive investor
- In case you are waiting for few months to decide, you are a moderate investor
- If your answer is “i will sell the stocks immediately”, you are a conservative investor
Here are certain tips to manage risks in stock market investing.
Understand how stock market works
Understand how the stock market works, things that affect the value of your stock and the risks involved in buying and selling a stock. It will help you to gain a very good knowledge of the share market to take your decision at any circumstances.
Try to understand why stock prices go up and down.
Which means, if you don’t understand the share market, then don’t invest. Better to take help of a financial expert or mutual fund.
The more you learn, the more you know about the stock market. This process will help you pick quality stocks.
To manage risks set up an emergency fund
You should always have an emergency fund. It’s not that you have to have it only when you start stock market investing. You have to set up an emergency fund to take care of temporary financial needs.
Five to six month’s living expenses are enough to set up an emergency fund.
Choose the investment to achieve your short-term goal
Stock market investing is not for your short term goals.
Therefore, you need to choose the investments that are most likely can help you to achieve your short term objective. For example, if you want to fund your children’s education which begins three years hence, you can not take the risk of putting it in the stock market. You can keep accumulating this fund in any risk free liquid investments.
You should start stock market investing to fund your medium term and long term goals.
Don’t take debt to invest in the stock market
Many market participants start their investing by taking personal loans from banks and financial institutions. Market experts strictly suggest not to do that.
Infact, you should reduce your unnecessary debts to have funds available for investing in stocks.
If your current debts are such that you are unable to fund stock investing, then try to have additional part time income. You can try making money online with the comfort of your home.
Diversify to reduce risks
Diversification is the best way to reduce risks of investing in stocks.
For better diversification, invest at least in 20 different stocks of different industries.
You can keep one or two stocks of the same industry, that’s fine, but don’t put money in one stock or in a number of stocks of one particular industry.
Here is what you should not do:
- Don’t put all of your money in one stock.
- Don’t even put all of your money in a number of stocks of one industry.
However, you can not diversify market risks as it is related to the stock market in general and has no relation to company or industry specific risk.
In order to minimize your losses to market risks, experts suggest investing in the stock market for the long term, more than 5 years. If you have a short term view, then better to go for risk free investments.
Do your own research before taking risks
Investing in stock requires research and hard work before putting your money in it. You should do your own research instead of blindly
Investing based on other’s research.
You can use all the financial tools available to know the fundamentals of the stock. If the stock is fundamentally sound, buy it at the right price at the right time.
Remember, over a long period of time, stock prices tend to appreciate in relation to their intrinsic value, which is associated with a company’s fundamentals.
Allocation of money into the stock market also depends on the investor’s age. As a thumb rule, you can deduct your age out of number 100 and invest that much percentage of your total amount available in stocks. The balance percentage of money can be invested in risk free investments.
For example, if your age is 40 years, then deduct 40 out of number 100. You got 60 (100-40). You should invest 60% of your total available amount for investment in stocks and balance 40% you should put in risk-free government securities.
Based on your risk appetite, you can reduce or raise your percentage of investment in stocks, but, make sure that you have funds to take care of your short term and mid term financial goals.
We have different types of stocks classified based on the type of return investors are seeking. These are income stock, value stock and growth stocks.
Blue-chip income stocks are less risky as they have a stable earning and proven track record of managing economic downturn.
Growth stocks are high risk and high return stocks as they grow higher than the industry based on the economic condition.
If you are still not sure how to go for stock market investing, then take help of a financial expert to help you out. Or, you can invest in 4 to 5 different types of mutual funds based on your financial goals. It’s better if you invest through a SIP route.