 | My neighbor pulled out the dusty can of concern, blew of the debris on the lid and opened up to me. She said, "Stock Trading is too risky". We were discussing Investments and Reports from AutoZone and Advanced Auto Parts. An Accountant by Trade, well-seasoned in the Industry, I often look to her for affirmation when I have concerns from Reports. Her and her Ex-Husband lost a lot of money in the Market. He (The Ex-Husband) kept buying Stocks and losing money. He never consulted with his accountant Wife, ironically. Although this sentiment seems popular amongst those who have lost money, I consider the old cliche, "If at first you don't succeed, try, try, and try again". |
Let's take a look at the basic theory of this all. Stock Trading is a form of Investing that involves Buying and Selling Shares of Companies on a Stock Exchange. Stock Traders aim to profit two ways. Two ways that I'm aware! Most common is exploiting the fluctuations in the prices of the Stocks. The other by receiving Dividends. Dividends are a percentage of the profits generated by the Business held. However, Stock Trading involves various risks that can result in losses or reduced returns. Therefore, it is important for stock traders to understand and manage these risks effectively with Risk Reduction Strategy.
Understanding Two Investment Risk Strategies
Investing should involve research, strategy, and discipline. Strategies have many layers and at the surface I identify two. Unless we consider Careless Investing as a Strategy, then there would be three! If an Investor isn't throwing a dart at the wall and hoping for the best, I could corral him or her together with either the Risk Avoidance or the Risk Reduction Investors.
Adopting a Risk Avoidance Strategy would be not performing any activity that may carry risk and eliminating any exposure to risk of a potential loss. Risk Avoidance is different from Risk Reduction, which deals with mitigating potential losses by reducing the likelihood or severity of a possible loss. For example, a Risk-Avoidant Investor who is considering investing in an Oil Business may decide to avoid taking a stake in the Company's Stock because of Oil’s Political and Credit Risks. The Risk Avoidant Investor would likely lean towards Bonds offered by the Company. Meanwhile, an Investor with a Risk Reduction approach, to the same Oil Stocks, would diversify their Portfolio by purchasing the Oil Stocks, while buying Stocks in other Industries that could help offset any losses from the Oil Exposure.
Risk Avoidance can be beneficial for Investors who have a low tolerance for risk or who want to preserve their capital and avoid losses. However, risk avoidance has some drawbacks, such as missing out on potential opportunities for profit, growth, Tax Advantaged Dividends, or being too conservative and underperforming the Market or Broader Economy. With that, Risk Avoidance should be incorporated in a broader, "Plan," but not used as the only strategy for growing wealth.
Common Risks that Stock Traders Face and How they may be Reduced.
- Market Risk: This is the risk of losing money due to adverse movements in the overall Market or a specific Sector or Industry. Market risk can be influenced by various factors, such as Economic Conditions, Political Events, Natural Disasters, or Market Sentiment.
- To avoid Market risk Investors should utilize a, "Thermometer," to evaluate potential Market Risk levels. For example, the S&P 500, QQQ, or DJIA can help timing dynamics to reduce Market Risk. To focus more precisely on a particular Stock, one could utilize Sector related ETFs as a, "Thermometer". For example, before purchasing Stock in an Energy Company or Financial Company any Investor could use a relevant ETF like The Energy Select Sector SPDR® Fund (XLE) or The Financial Select Sector SPDR® Fund (XLF) to help gauge timing and risk. Some Traders will use Moving Averages of the Business being considered, to help decide upon a favorable, "Entry Point," or, "Exit Point".
- Stock Traders can also use Hedging techniques, such as buying Put Options or Inverse Exchange-Traded Funds (ETFs), that can protect them from downside movements in the Market or a specific Sector or Industry. Alternatively, and strategically thought-out, Stock Traders can also exit their positions' or reduce their Holdings when they anticipate a Market Downturn or Volatility in a Stock, Sector, or Industry.
- Use either Dollar Cost Averaging or Stop Loss Orders. Dollar Cost Averaging is an accumulation Strategy of purchasing fewer Shares, at a particular price, and increase the quantity of Shares over regular Intervals. For example, rather than purchasing $2,000 worth of Shares, the Investor may purchase $500 worth, at monthly intervals, over a four-month time Horizon. This might be favorable when, "Thermometers," are indicating inflated Prices and the Investor believes lower prices are possible in the near future. The latter is a reduction Strategy. With a Stop Loss Order, the Broker will trigger a Sell Order, for the Investor to exit or reduce holdings automatically. If the Price reaches a predetermined lower Price Point, a, "Sell Order," would be created. The hope might be to repurchase those Shares at a lower price, if the Stock continues to decline or simply, "Get Out".
- Liquidity risk: This is the risk of not being able to buy or sell a stock at a desired price or time due to low trading volume or high bid-ask spread. Liquidity risk can affect the profitability and efficiency of Stock Trading, as well as increase the transaction costs and slippage. To avoid liquidity risk, Stock Traders can trade Stocks that have high Trading Volume and low bid-ask spreads, or use Limit Orders instead of Market Orders to control the price and timing of their trades. Moreover, Stock Traders can also avoid Trading during illiquid periods, such as before or after Market hours, during holidays, or during major news events.
- Horizon risk: This is the risk of having a mismatch between the time horizon of the Investment and the time horizon of the Investor. Horizon risk can arise when an Investor’s financial needs or objectives change unexpectedly, forcing them to liquidate their positions prematurely or hold them longer than planned. This can result in losses or opportunity costs for the investor. To avoid horizon risk, Stock Traders should align their Trading Strategy with their Investment goals and time horizon. Investors should review them periodically to ensure they are still relevant and realistic. Furthermore, stock traders should also have an, "Exit Plan," for each Trade and stick to it regardless of Market conditions or emotions.
- Reinvestment risk: This is the risk of earning lower returns on the proceeds from Selling a Stock, or not reinvesting Dividends, than on the original Investment. Reinvestment risk can occur when Interest Rates are low or when there are fewer attractive opportunities in the Market. To avoid reinvestment risk, Stock Traders should reinvest their proceeds in Stocks that have similar or higher expected returns than their previous Investment. Additionally, Stock Traders should also diversify their Portfolio across different Sectors, Industries, and Asset Classes to reduce their dependence on a single source of Income.
Fundamental Analysis is Required to Reduce Investment Risk
Fundamental Analysis is not a guarantee of risk avoidance, as it cannot account for all the factors that may influence the Stock price, such as market sentiment, investor psychology, or unexpected events (CEO Resigning... etc.). Fundamental Analysis can be time-consuming and complex, as it requires a thorough understanding of the Company’s Business Model, Industry, Competitors, Financial Reports and Trends, and predict future prospects. Therefore, Fundamental Analysis should be used in conjunction with other methods of risk management, such as diversification, Hedging Techniques, or Technical Analysis (TA).
Risk Reduction Should Produce Better Gains in Wealth
In conclusion, Investors have never had more favorable conditions. Fees are minimal, information is abundant, and there are very helpful tools available to Manage Assets. Risk Reduction is a very important dynamic in Stock Trading that should help outperform no risk options. Many Investment Advisors recommend a 60/40 portfolio, depending on an individual's age, that incorporates both Risk Avoidance and Risk Reduction Strategies. Anyone that is passionate about Research, Business, and Managing Assets should be able to utilize an Online Broker, Spreadsheets, and the useful abundance of data on the Internet to outperform the Risk Avoidant Investor.
