Risk and Rewards

What happens if I make a mistake and lose money? Like gambling, many people don’t talk about their losses in the share market – only their gains. This is a reason for the hype and also the fear first time investors have when investing in the financial markets. But with a little bit of knowledge and research, most investors can decide for themselves how they want to invest – or their “risk profile”.

So what happens when things go badly? Firstly, you could lose all your money – this occurs when a company does not have enough money to pay their debts – even when they sell all their assets. The other is that the share price drops because there was an adverse event that was “material” (impact the stock price). The two main risks are that you lose all your money, or you lose some of your money.

So how do you stop this from happening? The first risk you can reduce is by picking quality companies to invest in. Research is the key here – and more on how to pick the winners later.

Secondly, volatility in share price is due to investor demand and supply, which is influenced by a number of factors. Most savvy investors are in for the long term – this is around 5 years, where a company is rewarded for their long term projects and reap the benefits. Over a year, a company will do a number of things, results will be released, acquisitions, divestments etc, however if you stick with the fundamentals, its hard to go wrong. The fundamentals are relatively simple – if you believe the underlying business is growing and their strategies are sound and successfully executable – then this means their long term future is bright. Given these strong fundamentals, share prices will rise over the long term – this is called Capital Gains (when the current price exceeds the purchase price). This is basically just riding out the short term volatility, which has little effect on the long term investor.

Reducing risk - diversification

One method of reducing your risk is to hold a diversified portfolio. The old saying about never putting all your eggs in one basket applies to the stock market and investing too – the only difference is that it is called diversification. The more diversified you are, the more insulated you will be from company specific shocks (be it good or bad) and the more your portfolio will reflect the overall trend of the stock market. This linkage to the overall trend of the market is measured by the R-Squared statistic.