In the stock market, risk is ever present, but it’s always variable and unpredictable. A host of factors can increase risk, some of which are within your control and others of which aren’t. Although you can’t eliminate risk, you can often reduce your exposure to it by becoming more aware of the factors that influence it. Investors mitigate their risks by dealing with factors they can control.
Reducing human error
Human error is the biggest risk factor with investing, and it can come in many forms:
Lack of research and analysis
Choosing the wrong investment strategy for your stated goals
Failure to monitor market conditions
Choosing stocks emotionally rather than rationally
Letting fear and panic influence investment decisions
The best way to remove human error from the equation is to do your homework. If you’ve ever taken an exam you haven’t studied for, you know the risk involved in not being prepared. In addition to having no idea what the answers are, panic sets in to make matters worse.
Investing without emotion
One of the prevailing theories about the mechanics of the stock market is called the Efficient Market Hypothesis. It describes investors as rational people processing all the available information in the market to make logical decisions for maximum profits. But the truth of the matter is that most people aren’t rational or logical investors. They buy stocks on tips from friends or even strangers, because of something they heard on the news, or because a company makes a product they love and are sure it’s going to be a big hit. They know nothing about the company, its management, or the stock’s history.
Don’t let emotions govern your investment decisions. Remain particularly cautious of the following emotions:
Greed: Greed often seduces investors into making terrible decisions. During market rallies, investors often succumb to a herd mentality, throwing their money into the hottest sectors and companies, inflating a bubble that invariably bursts. Greedy investors often tend to make bets they can’t afford to lose and then fall into the trap of making even bigger bets to recover their losses.
Fear: Fear is the flip side of greed. People who previously lost money in the market, or just witnessed the pain felt by others, can experience such a massive fear of losing money that it paralyzes them from doing anything. Instead of taking on some risk with suitable investments, they put their money in low-risk investments with poor rates of return.
Love: Don’t fall in love with your investments. They don’t return your love but have a good chance of hurting and betraying you. All too often, people refuse to sell when stocks begin to fall because they really believe in the company. Yet, when a stock falls sharply on very bad news, you need to bail out. Remember, you’re not married to a stock. On a regular basis, look at your stocks and ask them, “What have you done for me lately?” If the answer doesn’t satisfy you, you can unceremoniously dump them without hurting anyone’s feelings. And because stocks are very liquid, you can get rid of shares immediately.
Spreading your nest egg among several baskets
Regardless of how promising a company is, you should never invest all your money in it. Management may be incompetent or corrupt. Competitors may claim more market share. Or the company or its entire sector can lose investors’ favor for whatever reason.
The good news is that you have total control over where you invest your money. You can significantly reduce your risk by spreading it out through diversification.