Accept Reasonable Risks
The following is extracted directly from my book Family Financial Freedom. You can find similar informations about managing investment risks in my book, Figuring Out Wall Street.
Many books have been written on the subjects of fundamental analysis and technical analysis, so we will not go into those subjects here. What's is important is understanding that every investment (even the decision not to invest) contains risks and you should understand those risks and what your tolerance is for taking risks to get better returns.
Risks involved in evaluating investments, including possible loss, which usually results from action or inaction based on the facts known. The ability to tackle risk depends on your make-up and the value expected in taking the risk. By properly evaluating the risks you are willing to take, you can better determine if the expected value of the investment is worth the risk taken.
Risk Tolerance Surveys
Most investment advisors will help you evaluate your risk tolerance, normally with a survey. You can also go online and complete a survey on your own to help you understand your tolerance for taking risks when making investments. I have including links to a few here:
Merrill Lynch: Risk Tolerance Evaluator
Wells Fargo: https://www.wellsfargo.com/retirement/tools/assetallocation/generic
Yahoo Finance Risk Tolerance survey
I would encourage you to take one or more of these surveys to better understand how you view risk in investing. Purchasing stock involves an element of risk not present in making a decision to place money in an insured bank deposit-- the risk of losing your money. In this context, risk refers to the element of uncertainty –the chance that something unexpected and undesirable will happen. Let’s look at the types of risks that must be evaluated before investing money.
Financial risks, also known as credit risk, business risk or operating risk refer to uncertainty about a company in which one might choose to invest. Financial risk centers on a simple question: “If I invest my money in this company, will I get it back, along with the expected returns?” No business is a guaranteed success. Investing money in a business is a financial risk. Some investments carry a higher degree of financial risk that others. Preferred stocks have more risk than bonds, because a corporation is not required to pay dividends, but are pledged to repay the interest on a bond. Common stocks have a higher financial risk. If a company fails, stockholders are last in line among creditors entitled to recoup their money.
Market risks refers to the investment or stock itself at the time the investor may want to sell it to someone else. The risk is that there will be no market (or buyers) for that investment or the market will be so poor that you must sell for less than your originally paid for the investment, simply because of changes in the value of the investment when compared to other investments of a similar nature. Bonds carry market risk, because changes in interest rates make bonds worth more or less than their face value based on current conditions.
Interest Rate Risks
Interest rate risk is the uncertainty about future changes in the rates of interest. For example, a bank certificate of deposit is purchased for a long time at a fixed rate of interest. If interest rates change, there is a risk that the holder of the certificate of deposit has lost the opportunity to invest at a higher rate. This is sometimes calls “opportunity cost.”
Management risk involves the possibility that an investment or business will be poorly managed. In most cases, it really doesn’t matter whether a loss occurs because finances were managed dishonestly or ineptly, your investment might be gone. Poor management can turn any investment into a financial loss. An investor can evaluate the past performance of a business or ask an investment advisor to help determine if the management team is honest, capable and able to produce the results expected.
Rules of Successful Stock Investing
Now you have a picture of what goes into building financial freedom for you and your family. Although your building will not look like anyone else’s, the basic blueprint works the same for everyone. Successful investing requires some self-discipline. The following guidelines are suggestions to help you become financially free, if you are determined to be a stock investor. Use this approach only if you have the time and interest to follow your investments closely. Most of us are happy just to have a simple investment plan in plan.
When investing in stocks, these rules work:
Have an emergency fund – Do not start investing, unless you have three to six month of your normal income in a savings account, money market fund or certificates of deposit. This is money you need to protect yourself. Call it a rainy day fund.
First open a trading account. Start with cash only, a margin account can come later after you know what you are doing.
New investor: seek out a good full-service brokerage and work with someone with an established track record.
Experienced investor: use a discount brokerage, remember service and quality count.
Determine your starting point, and buy stocks as follows:
If you are starting with $1,000, buy one stock and consider using a dividend reinvesting plan or DRiP to continue to invest in that stock.
Dividend reinvesting allows your investment to grow more quickly, because each dividend payment buys more shares in the company and you can often buy fractional shares for a fixed monthly investment.
If you are starting with $5,000 or less only buy two stocks.
With $10,000 buy two to three shares
Once you have $25,000 to invest, increase too just four of the best stocks you can find.
With $100,000 to invest expand to six companies.
Never buy more than 20 stocks, unless you are able to invest full-time. It is just too difficult to keep up on all of the details if you are trying to manage more than 20 stocks. It would be just as easy to invest in a quality mutual fund or hire an asset manager.
Buy the very best companies. Do the research and concentrate on a limited number of companies in businesses you understand. Then watch these stocks like a hawk, using stock alerts to follow changes in pricing, and catching the latest news on earnings and the like.
Cut losses on stocks at eight percent, by placing stop loss orders on all of your positions. This prevents you from holding on to favored stocks based on gut feeling. A stop loss order is like fire insurance and it helps to take out emotions of investing. You now have a rational tool to control losses and have money to reinvest in the next best stock. If you are buying the best companies, then chances art the stop loss orders may not be evoked, but the insurance is there if you need it.
Set a target to sell your best stocks with 25% to 30% gains. I know it will be tough to sell a winner, but investing in stocks is about making money and you don’t need to stay in a stock until it reaches a top.
When looking at your stock positions, always sell your worst performing stocks first, not your best.
Pick stocks from market leaders, in leading sectors. Find the stocks that are number one in their sector, with strong return on equity (ROE), strong profits, and sales and earnings growth.
Look for companies with earnings per share (EPS) that are up for three years in a roll, and where sales and earnings are up at least ten percent each quarter for a year. Return on equity should be 17 percent or more and finally stay with the companies that are number one in their industry sector.
Last set your selling targets. Cut losses at eight percent, sell if the price earnings ratio (P/E) is 130% or more, or when the growth rate exceeds 15 percent.
These are the basic guidelines you need to get started, but be sure and continue to read and learn more about investing as you grow.
Remembering to start investing when you have developed a sound common sense foundation with an emergency fund and the proper amounts of insurance, will help back investing easier. Take is a step at a time and over a few years your efforts will pay off.