More than a few investment plans have gone awry after a sudden drop in the value of a portfolio or individual stock. It’s a sickening feeling when watching thousands of your hard earned dollars virtually disappear over the course of a few days, but if you’re in the market long enough you’re pretty much guaranteed to experience it at some point. The risk that comes along with a fluctuating market is one that you can never get away with, but if managed properly you can use it to your advantage to profit greatly in the long run.
It’s important to first understand your personal ability to handle the risk that comes along with investing, and also how to use risk to ultimately meet your financial goals.
Finding the right balance between risk-reward
Risk is fundamental to investing. You’ve got to understand that the market rewards people for investing money at different levels of risk. Investors that want guaranteed appreciation of funds can invest in very low risk investments like government savings bonds. You’ll be guaranteed a positive return, but in exchange for this guarantee, you’ll also earn a minuscule return on your investment. If you’re willing to take a little more risk, you could invest in something a tad riskier, say bonds of very safe companies. In doing this, you’ll earn a greater return than your savings bonds. Stock market investors deal with even higher risk, and in turn have the opportunity to be rewarded greatly when stock prices skyrocket.
You can see the connection between risk/reward demonstrated in the table below. A few of the most common market investments are listed alongside their average annual returns, associated risk, and risk adjusted return (a measure of how much return an investment earned relative to it’s risk). Notice that as investors are willing to risk their money with progressively riskier investments, they generally see higher returns.
|Type of Investment||Return||Risk||Risk Adjusted Return|
|Corporate Fixed Income||5.5%||8.5%||64.7%|
|Large Value Equities||8.5%||13.3%||64.2%|
|International Fixed Income||6.0%||13.3%||45.3%|
|Large Growth Equities||9.6%||16.0%||60.0%|
|Small Value Equities||10.0%||18.8%||53.3%|
|Small Growth Equities||11.1%||22.0%||50.5%|
Understand your ability & willingness to tolerate risk
You absolutely must understand your personal tolerance for risk. Neglecting this crucial step, and investing in assets above your personal risk level could send you on an unworthy emotional roller coaster as the market fluctuates, and could also cause you to face panic selling which never helps you reach your goals.
Your ability to tolerate risk depends on a few different factors such as your age, how much money you need now and at retirement, and also the size of your current portfolio. Young investors with a large portfolio and no current need for their investment dollars have the ability to tolerate larger swings in portfolio value with the hope that returns will be higher over the long-term. Conversely, investors with just a few years to retirement have much more to lose if the market takes a steep dive. They know they’ll soon be withdrawing these funds to use as their primary source of income, and if the market takes a dip they won’t have time on their side to allow the market to recover like the younger investors.
Your willingness to tolerate risk also depends on your own attitude and nerves. The gamblers and risk takers out there might be able to see their portfolio take a 30% dip without blinking an eye, while others would go into personal meltdown mode when being faced with the same scenario. Remember, there are thousands of investments you can make, and also many unique paths to reaching your investment goals. You should plan for, and invest according to your own personal strategy that meets your financial goals, and also suits your tolerance for risk.
Beta: A technical term for a simple idea
After you’ve discovered your personal tolerance for risk you can then begin to incorporate stock volatility into your analysis as you scan the market for possible investments. Doing this is really quite simple; analysts have already developed & calculated this measurement for you. It’s called beta, and is simply the measurement of an individual stock’s volatility compared to the rest of the market. Put another way, how much does this stock’s price move compared to the overall market?
Stocks with a beta of 1 tend to fluctuate in price at the same rate as the general market (for this measure, the market being defined as the S&P 500). If the S&P tends to fluctuate say 1.5% on a given day, a stock with the beta of 1 will theoretically have a price that also fluctuates about 1.5% on any given day as well.
Stocks with a beta of less than 1 are less volatile than the market, while stocks with a beta over 1 are more volatile than the market.
Lets take a look at a practical example of beta by examining two different stocks.
MGM Resorts (MGM) currently has a beta of 2.06, which means its stock price is about twice as volatile as the general market. You can see from the chart below exactly how volatile it was over the course of a recent 5 day period. Intra-day swings in the stock’s price range anywhere from 1.2% to 2.8% of it’s overall value. Over the course of 5 days of trading the total swing from it’s lowest price to highest was 4.7%. You’ll also see on some days there are significant differences between it’s opening price, and closing price the night before. This is another sign of a higher volatility stock.
Now, lets look at shares of the Coca-Cola Company (KO) which currently has a beta of just 0.26, an indication that KO is much less lower volatile than the general market. We’d expect fluctuations in price to be small, and to see a much smoother graph than that of MGM. In looking at the chart below that’s exactly what we see. The highest intra-day swing was only 1.1%, which was lower than MGM’s lowest swing on any of the same 5 days of trading. You’ll also see very few instances of significant differences between opening/closing prices, and also a total 5 day swing that’s much less than MGM’s.
Diversify to mitigate your total risk
What if I told you that you can invest in companies like MGM (twice as volatile as the market), but still hold a portfolio with a volatility level close to that of the overall market? This is where diversification comes in! By properly diversifying your investments, you can balance out the large fluctuations of any individual stock. You’ll essentially be using the fluctuations of multiple stocks against each other in order to hold a portfolio that grows steadily over time.
The concept of diversification is really where investors can see the best gains. By doing your homework and putting together a well-rounded portfolio of strong individual companies, you can reduce the overall risk in your portfolio while still benefiting from the higher return that comes along with higher beta stocks.
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