Many people know they should be investing, but fear of loss keeps many from participating in financial markets. After all, nobody wants to lose their hard-earned money, and you often hear warnings about how poor investment decisions can lead to significant losses in the stock market.
However, building wealth on Wall Street doesn’t have to be scary. Although there are market risks, they can be overcome.
Even the biggest risks of investing — volatility, timing, and overconfidence — can be sidestepped as long as you know they exist and take an active stance on combating them.
Here are the three biggest risks of investing and how you can go about protecting yourself from them.
Investment Risk #1: Volatility
Volatility is a term used to describe the rate of short-term fluctuations in stock prices.
Stocks that experience more volatility — significant movement over a short period of time — are considered higher-risk investments, while stocks that experience more slow-and-steady movement are considered lower-risk.
Causes of Volatility
Stocks become more volatile when specific events take place. Although volatility reflects the rate at which a stock moves, it does not determine the direction of the movement. In other words, volatility is higher on sharp movements both up and down.
Some types of events that lead to the most dramatic moves in financial markets include:
The economy is global. Because of international trade, a change in legislation in China could result in increased prices and economic impacts here in the United States. The same goes for any other major economy and several emerging and developing economies around the world.
So, it’s important to pay close attention to what’s going on on the geopolitical stage for clues as to how prices will move in the U.S. market.
The market is all about investing in companies, and companies tend to do best when economic conditions are positive. Conversely, when economic conditions are negative, companies tend to struggle.
As major economic events take place, the market generally experiences fast-paced movement. As such, it’s important to pay attention to economic reports, changes in U.S. monetary policy, and updates to the Federal Reserve interest rate.
Inflation levels also have the potential to lead to rapid changes in stock prices. When inflation levels are high, the dollar loses value at a faster rate than expected. This creates a burden for companies, which could lead to declines, often causing a shakeup in financial markets.
Investor interest also plays a huge role in price movements. After all, stock prices move based on the law of supply and demand.
When demand for shares of a stock rises, the available supply shrinks and prices must go up. When demand for shares is low and investors begin selling, the supply grows, leading to price declines.
The fact that retail investor interest plays such a huge role in the rate at which stock prices move became more clear than ever in early 2021 when a group of WallStreetBets Reddit users caused the Big Short Squeeze, sending the prices of GameStop, BlackBerry, and Express stocks flying.
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How Volatility Is Measured
The rate of short-term price movements in stocks is measured using beta, a metric that expresses the correlation between a security’s price and a benchmark.
In most cases, the benchmark used is the S&P 500 index because the stocks listed on this index represent more than 70% of the entire U.S. publicly traded market capitalization.
Here are some examples of how beta reflects a stock’s volatility compared to the benchmark:
- Slowest Price Movements. Securities that experience the slowest price movements have a beta of less than 1. For example, a beta of 0.5 suggests that if the S&P 500 moves by 10%, the stock will generally move by just 5%.
- Average Price Movements. Stocks with a beta of exactly 1 move in the same direction at the same pace as the whole market. For example, a stock with a beta around 1 is closely correlated with the broader economy and will generally move 10% when the S&P 500 moves 10%.
- Fastest Price Movements. The most volatile stocks on the market will trade with a beta of more than 1. For example, a stock with a beta of 1.5 will generally move 15% if the market moves 10%. Keep in mind that stocks with the fastest price movements come with higher risk.
According to Invesco, investing in stocks that are less volatile often gives the investor the ability to outperform the market in the long term.
The fund management firm points to the fact that investors are often willing to take higher risks in hopes of a jackpot, but that slow, steady gains on low-risk stocks have the potential to yield the best long-term returns.
How to Protect Yourself From Volatility
You don’t have to accept the high risks that come along with investing in highly volatile stocks. Instead, it’s possible to protect yourself from significant changes in stock prices using the following strategies:
Mix Bonds Into Your Portfolio
Asset allocation is a key factor in any investment portfolio. A well-balanced portfolio includes a good mix of asset classes, including not just stocks, but lower-volatility corporate and treasury bonds.
Bonds tend to experience incredibly slow price movements, helping investors maintain value in their portfolios in a market downturn.
Pay Attention to Market Capitalization
Stocks that move the fastest tend to be in the penny-cap and small-cap categories. More well-established companies with large market caps will experience more steady movement, reducing the risk associated with the investment.
Moreover, large-cap stocks also experience high levels of liquidity, making it easy to cash in when it’s time to exit your position.
Buy Stocks With Consistent Dividend Growth
Companies that pay sustainably high dividends and generate consistent dividend growth are usually far less volatile than other stocks.
Buy Stocks With a Low Beta
When reviewing stocks you’re interested in buying, pay attention to their beta measurement. If you’re trying to avoid volatility, only invest in stocks with a beta of 1 or less to avoid stocks that are prone to significant changes in price.
Hedge Your Bets
Hedging is the process of purchasing positions on both sides of the coin. For example, you might invest in one position that would profit when the stock price moves up and another position that would profit when the stock moves down.
Although finding a balance that produces meaningful profits while minimizing risk is difficult to find, with a bit of research and practice on trading simulators, you can develop a strong hedging strategy.
Investment Risk #2: Timing
The term “time is money” is nowhere more true than it is on Wall Street. Prices move by the second, and pinning down the best time to buy or sell a stock proves to be difficult for experts and retail investors alike.
After all, although the goal is to buy low and sell high, without the ability to predict the future, there’s no way to tell where “low” and “high” sit.
Imagine buying a ton of stock when optimism is running high — right before the market crashes. Or giving in to panic and selling during a market meltdown, right before a major rebound begins.
Poorly timed investments will prove costly.
According to Hartford Funds, timing the market is impossible. In fact, experts at the firm point to the fact that 74% of the best days on Wall Street occur during bear markets, which are times when investors are told to exit their positions.
Furthermore, missing the 10 best days in the stock market over the past 30 years would have cut your overall returns in half.
How to Protect Yourself From Timing Risks
Time is of the essence, and one of the best ways to protect yourself from timing risks is to start investing right away and take a long-term approach when you do.
Invest With a Longer Time Horizon
Timing the market is akin to predicting the future, and long-term predictions based on general facts tend to be more successful than short-term guesses. For example, if you said it was going to rain in the Mojave Desert tomorrow, chances are you would be wrong.
On the other hand, if you said it was going to rain in the Mojave at some point over the next year, you’d probably be right because the Mojave gets about 7 inches of rain per year.
The same concept relates to Wall Street. If you were to predict a stock is going to go up in the next hour, day, or even week, your chances of being correct are far less than with an educated prediction that a stock will see significant gains over the next several years.
Use Dollar-Cost Averaging
Dollar-cost averaging is a strategy based on spreading your buys and sells over time on a specific schedule.
For example, if you plan on buying 1,000 shares of a stock, instead of buying all 1,000 shares right away, you would buy 100 shares per week over the course of 10 weeks.
Through this strategy, your purchase price averages out based on the movement of the stock. So, purchases at high prices are balanced by purchases at low prices, ultimately reducing your risk of buying in at the wrong time.
Stick to Your Investment Strategy
Wise investors follow a tried-and-true investing strategy. Strategies like value investing and growth investing essentially outline when it’s time to buy and sell stocks, taking timing decisions out of your hands and reducing your risk.
Investment Risk #3: Overconfidence
You often hear that you shouldn’t invest based on emotion, that fear and greed work to the detriment of investors, and that you should follow a clear, concise strategy when investing.
All of this is true. But the topic of overconfidence doesn’t get discussed often enough.
Whether you find success in sports, your career, or Wall Street, you’re not likely to blame your success on luck. No, that success is the result of hard work. To think this way is human and entirely natural.
But don’t let your successes lead to a big head. When people become overconfident, they tend to make mistakes. This is the case in the office, on the field, and in the stock market.
There are several major mistakes investors make when they become overconfident:
- Overuse of Leverage. Leverage gives investors the ability to trade larger numbers of shares, units of currency, or other assets with smaller initial investment amounts. However, this leverage is a loan, and it costs money. Moreover, when things go the wrong way, losses are exacerbated.
- Failure to Recognize Biases. Biased decisions in the market are often losing decisions. However, if you become overconfident, it will become difficult to admit your biases to individual stocks, industries, or asset types, which could cut into your gains, or worse, lead to losses.
- Aggressive Timing Attempts. Timing the market is tempting to almost every investor, but the vast majority of financial professionals suggest it is next to impossible, even for experts. Overconfident investors often make attempts to time the market with short-term trades, resulting in significant losses when their short-term predictions prove to be wrong.
How to Protect Yourself From Overconfidence
As a human being, you’ll likely find it difficult to spot when your overconfidence may lead to losses in the stock market. Nonetheless, following the tips below will help you stick to your strategy and keep confidence in check.
Diversification is the process of spreading your investment dollars across different types of investments.
A well-diversified portfolio will include a long list of stocks or investment funds as well as safe-haven assets like bonds. By diversifying your investments, if a single asset loses value, gains across the rest of your portfolio will dampen the blow.
Diversification also helps to ensure you never put too many of your eggs in one basket as a result of confidence that your investment will be a successful one.
Invest in Investment-Grade Funds
Investing in individual stocks opens the door to a lack of diversification. However, investment-grade funds like exchange-traded funds (ETFs), mutual funds, and index funds provide exposure to a diversified list of individual stocks and other financial instruments.
Investing in these investment-grade funds takes some of the control over what you invest in and when out of your hands and into the hands of some of the most highly respected professionals on Wall Street.
Follow Your Investment Strategy
Your investment strategy will outline the types of stocks to invest in, when to buy, and when to sell. By sticking to your strategy when making investment decisions, you’ll cut emotions, including overconfidence, out of the equation.
Don’t Get Trapped In Leverage
Leverage is a dangerous concept that not only increases expenses associated with investing but can also lead to significant losses. As a result, unless you consider yourself an expert investor, it’s best to stay away from leverage.
Investing will always come with some risk of loss. At the end of the day, when you make an investment, you’re making an attempt to predict the future: you’re predicting the price of the asset you’re buying will increase over time.
Although things work out in a positive way the majority of the time when your investment decisions are well-researched and you stick to a strategy, losses are always possible.
Nonetheless, knowing of the existence of the three major risks associated with investing and making a conscious effort to protect yourself from them will likely result in better outcomes as you invest.