It’s not uncommon for a person to get caught up in the excitement of stock market activity and the subsequent enthusiasm for stocks that can yield significant gains. After all, it’s been an emotional roller coaster recently, and thankfully there aren’t signs of it abating any time soon. You might be wondering: Is it really time to “demystify” your stocks by getting rid of bad stocks and aiming for the obvious security of money? If so, you’ve come to the right place! Read on for some thoughts on risk/reward tradeoff and how to apply it to the current stock market situation.
Let’s start by examining the risk/reward tradeoff in relation to stocks. Stocks have greater volatility than bonds, so the risk of a major decline in stocks (and possible default as well) is greater than with bonds. But the potential reward, especially when you buy into top-notch companies, is also greater.
So how do you weigh the risk/reward tradeoff when choosing between stocks and bonds? One way is to look at risk relative to potential return. For instance, a company with a long history of profits but high debt to equity ratios could be a good bet over the longer-term interest rate outlook. A company with high profits but low interest rates would not be a good bet, as the cost of financing the debt increases.
Another approach is to compare current share prices to book value. If current share prices are more than book value, then it’s a good idea to own those stocks, although this is not the most efficient use of your money. On the other hand, if you are able to buy low and sell high, the shares will appreciate, potentially providing a large return on your initial investment. Again, it is difficult to determine which approach is best.
One of the least common, but still profitable, methods of evaluating stock market risk involves identifying “growth oriented” stocks. Growth stocks have the advantage of rising in value because they are able to sustain higher prices for time. This provides you with a potential rate of return that is significantly higher than that of traditional securities. Unfortunately, growth-oriented securities also come with the additional drawback of being more difficult to market.
A third option for evaluating risk involves looking at less risky alternatives, such as corporate bonds. Since bonds carry less risk than the stocks themselves, the coupon, or interest rate, on the bond is less important than the overall value of the portfolio. Additionally, corporate bonds carry less risk than most types of stocks due to their size, stable banking structure and long-term borrowing limits.
A fourth option for evaluating risk involves looking at mutual funds that focus on growth-oriented investments. By using these funds, you can eliminate the need to evaluate individual stocks or even whole mutual funds. Instead, you can choose to invest in companies that pay dividends that are consistently rising.
Whether you are interested in buying individual stocks or in mutual funds that invest in a variety of stocks, it is important that you understand the risks and rewards that you can realize through your investment. In order to do this, it is important to consider the differing characteristics between stocks and mutual funds. This way, you will be able to intelligently select investments that will help you grow your wealth over time.
In addition to considering the benefits of different investments, there are several risk considerations that should also be addressed. First, potential investors should determine if their portfolio is composed of a combination of stocks and/or other types of investments. In general, investors who invest in both types of portfolios are considered less risk-takers than those who maintain only one type of portfolio. Moreover, investors may be limited in the amount of stocks that they can purchase since the total assets of their portfolio may decrease if a particular investment loses its value.
For some investors, using both types of portfolios is not feasible, especially if they don’t have enough cash on hand. The best ways to minimize the risk of investing in dividend-paying stocks without negatively affecting your savings account is diversifying your portfolio. Diversification may involve investing in bonds, money market funds, real estate stocks and other fixed return categories, as well as investing in either stocks or in both stocks and savings accounts.
Another risk factor that should be considered is the risk that returns will remain low over time. Determining your risk tolerance is an important first step when planning your portfolio. An asset’s risk-return relationship gives portfolio managers an idea of how much of the returns will be reserved for taxes and insurance and how much will be used to offset operational costs. An ideal risk capacity is one that is two to three times your annual income.