INVESTMENT RISKS PRIMER
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UNDERSTANDING RISKAll money making ventures involve investment risks of one sort or another. On the surface it appears that investing is simply a matter of finding the highest return and sticking your money in that investment. If only it was that simple. The main problem is that higher returns typically mean higher investment risks. Risk drives expected returns. The greater the investment risks, the greater the expected return needed to attract investors. Putting money in Federally insured savings accounts creates investment risks. Low risk, insured savings accounts pay less than many other investments; they also give the investor little or no protection against inflation. Even investing in treasury bills and notes carries a few investment risks. For example, inflation adjusted Treasury Securities have lower starting returns than many other investments in bonds or notes. Investing in stocks has the potential of losing your money, or capital. This is called ‘capital risk’. A condensed discussion of capital risk and other investment risk terms can be seen on the Wikipedia Investment Risk page. Another investment risk term you will want to understand is Beta Coefficient which measures volatility or stability of returns. Stocks with a high rate of return often have a high beta coefficient. Such a stock might return 30% in a good year but could also fall 30% in a bad year. Low beta stocks might return only 8% in a good year but they might still return, say, 2% in a bad year. Investment risks and investing go hand in hand. There are countless ways to lose investment money. The investment pitfalls shown below will be a helpful primer for those new to investing. Bear in mind that this is only a primer; volumes have been written on the subject of investment risks. _________________________________________________________________
INVESTMENT RISKS TO AVOID_________________________________________________________________
SPECULATING RATHER THAN INVESTING - One of the most important things to learn about investing is the difference between speculating and investing. Investing is a long term, conservative plan to grow wealth over time, often several decades. Speculating is much more about turning a large, quick profit, if you’re lucky. There are endless fast buck investment ideas. Some, very few, people make money with them. But for most of us they are big time money losers. Speculating in all forms involves high investment risks. In almost every instance, speculating should only be done by those extremely knowledgeable in the field of speculation. If you see a speculative offering that you just can’t resist, you should at least limit your risk. Bob Brinker, a highly respected market analyst, suggests that, no matter how irresistible an offering may sound, NEVER put more than 5% of your investment funds into it. When you look at our energy investing pages you will see some speculative offerings. They will carry a clear warning stating that most of those kinds of offerings lose money. _________________________________________________________________
MARKET TIMING - Market timing is often used as a form of speculating. Market timers believe they can watch indicators such as interest rates, stock prices, and an array of other information to determine whether stock prices will be more likely to increase or decrease in the future. Market timing can take on a number of forms including some technical systems that suggest jumping in and out of the stock market a number of times each day. This type of market timing is highly speculative, with equally high investment risks, and simply isn’t for most of us. Yes, some minute-by-minute timing traders do make money, but they spend years learning the game. At this level, market timing is a lot like playing poker. The rare few who spend the time and effort it takes to both master and play the game can make money, everyone else loses. Some, also a very few, seem to be able to predict longer-term price trends with a degree of accuracy. Market timers like Bob Brinker look for long-term trends that can affect overall market prices for months. Used properly, this form of market timing has proven profitable to many, at least so far. Of course, past results are not a guarantee of future performance. An old Wall Street adage states that market timers have predicted 7 out of the last 4 market reversals. In other words, market timing systems can sometimes tell timers to get out of a market when they should stay in. The end result is that gains saved by being out of the market at the right time are often offset by opportunities lost from being out of the market at the wrong time. There are a lot of newsletters that promote market timing systems. Before you buy one of these financial newsletters, and especially before you invest your money based on advice from one of them, check out the Free 30 Day Trial of MarketWatchs' Hulbert Interactive Newsletter
The Hulbert Interactive team uses computer analysis to determine the effectiveness, or lack of effectiveness, of advice given in over 180 financial newsletters. Hulbert’s advice is so well respected that most subscribers won’t give any financial newsletter a second look unless it earns a high ranking with Hulbert. Should a conservative investor use some means of market timing to increase profits, or protect them? There really isn’t a good, solid answer to that question. Some very conservative investors are total believers in following long term timing systems with long track records of success. Other conservative investors believe in putting their money into stock market investments and leaving it there. Both have made money over the years. Both have had some losses. _________________________________________________________________ _________________________________________________________________
COMMODOTIES – Commodities like wheat, orange juice, oil, and many others are also plays that should be left to the pros. Here again, there is money to be made, but it will be made by experts who have spent years learning the game, and spend endless hours analyzing the day-to-day information that affects commodity prices. The same thing applies to currency and all other forms of speculative trading. If you’re not one of the experts, avoid these investment risks and save your money. _________________________________________________________________
INDIVIDUAL STOCKS – The problem with investing in individual stocks is similar to the problem with market timing. Many of these kinds of transactions are made with the hope of making large, short-term profits. If you’re wrong, you’re setting yourself up to lose a lot of money. And even if you’re right, you are almost certainly acting on information that has already circulated through the marketplace long enough to cause a significant price shift that eliminates most, if not all, of the profits you were after in the first place. How fast does the market respond to corporate news? In this age of microprocessors and light speed communications, the answer is stunningly fast. The market can respond, and adjust stock prices up or down according to the news at hand, in milliseconds. Sometimes it takes a few seconds to respond, maybe minutes, but rarely more. You should always be extremely wary about buying individual stocks because you hear a ‘hot’ tip that some company is about to release a great new thing-a-ma-jig that will be more important to mankind than penicillin. You can make money with individual stocks. But you need to be careful. Stick to that 5% limit that restricts investment risks on any one investment to 5% of your total funds invested. Buy with the expectation of holding the stocks for the long term, which is often measured in years. And you should have an in depth knowledge of the company behind the stock you want to purchase. One of the few exceptions regarding investment in individual stocks is the company investment plan. Investing in the company you work for is entirely proper and you can often buy the stock at healthy discounts through your employee stock ownership plan. And if you don’t think your employer is worth investing in, you really should consider working elsewhere. _________________________________________________________________
CAN’T MISS DEALS OR THE NEXT MICROSOFT –
Can’t miss deals usually involve individual stocks or an upstart company. To put it in simple terms, most can’t miss deals miss. There are endless sizzling hot deals out there. Most of them lose money. But some, a very rare few, do make money. How do you find the winners? One way, and it also has high investment risks, is to invest in a Venture Capital Firm that has a reputation for finding the one winner among the hundreds of losers out there. And there is no guarantee that a superb track record will mean success on the next investment. _________________________________________________________________
PHONE CALLS OR EMAILS SOLICITING YOUR INVESTMENT MONEY – Avoid these boiler room brokerage offerings like the plague. An investment boiler room brokerage is an operation that usually involves phone soliciting, but can include mail, email, or even door-to-door soliciting. It often involves high pressure to get your money into what are advertised as ultra hot investment deals. These types of operations have been linked to scams on high yield investment trading, real estate schemes, alternative energy investment scams, and countless other frauds. Boiler room brokerage offerings always sound irresistible. That’s how they separate people from their money. If the deal is real, one of the many reputable investment firms will know about it. Don’t buy a solicitor’s line that a neighbor or family member referred him. If that is really the case, don’t get in line with friends and family to get scammed. Boiler room brokerage scammers are endlessly creative. The fact that the ‘offer’ is coming from an unknown source, a company name you know nothing about, and with whom you have had no previous contact, is enough to tell you that you’re not interested. Remember, investment information travels at the speed of light. If an offer is really great, and legitimate, it will attract all the investment capital it needs in short order. It darn sure won’t need to solicit you for a few hundred or few thousand bucks of your hard earned money. _________________________________________________________________
EXCESSIVE LOADS –
Even if you avoid the many other investment risks you can still get stuck when you think you’re embarking on a conservative, solid investment plan. Every investment has some kind of financial load, or fee that is charged for managing the money. Even money you keep in a bank account earning interest has a load that is expressed in interest rates that are less than those charged to borrowers. Stock brokers charge a commission just to buy stocks. And paying a commission doesn’t necessarily mean that you’re getting good investment advice. Loaded funds can have loads of 3% or more. Some charge loads to buy into the fund, and yet another load when selling. Other fees can also be involved when buying, selling, or holding mutual funds. Other funds, specifically no-load funds, have no front end or back end load at all. These funds only charge a maintenance fee to manage the fund. Maintenance fees vary with the type of fund and with the company doing the investing. If you take just a few legitimate investing publications and study them, you can confidently do most of your investing without paying those big loads and excessive fees. It is noteworthy that whether or not a fund is loaded has no bearing on the quality of returns. Those extra loads often just cost you money. Some self-study now can save you many thousands by the time you retire. There are a few load funds with small loads that have great returns. Deciding which fund to invest in is a matter of shopping around to find the best combination of low fees and good long-term return expectations. _________________________________________________________________
PUTTING ALL OF YOUR INVESTMENT EGGS INTO ONE BASKET –
After your investments have grown beyond a few thousand dollars, you should consider diversifying. Most large investment portfolios have an array of funds that can range from very conservative Treasury Securities to funds involved in high risk venture capital firms, and a number of funds in between carrying varying levels of investment risks and returns. _________________________________________________________________
OVERDIVERSIFYING –
While it’s not usually a good idea to keep all of your funds in one investment, it’s also important to keep your portfolio manageable. A portfolio with much more than about 30 different types of investments pushes the upper limit of what most folks can properly manage. Something less than that number can still provide plenty of diversification and be manageable. As your investments grow and expand, and you continue improving your investment skills, you’ll need to find a level of diversification that best fits your needs and the size of your portfolio. _________________________________________________________________
THE ECONOMY -
Even if you do everything perfectly and make great investments, you can still lose. How bad can investment loses from economic downturns get? The worst economic downturn in American history was The Great Depression of the 1930s. Anyone considering an investment plan should have some understanding of that era and the changes it brought to free capitalistic nations around the world. _________________________________________________________________
NOT INVESTING – So, should you just stuff your money in a mattress or bury it in your back yard? If you do that your house could burn down, or someone could see you bury the loot and come back and dig it up. Year by year, bit by bit, inflation will eat away your cache. And You will lose any chance to earn income from your money. Not investing means that the only way you will ever produce income is to work for it. Investing gives you the means to make your money do the work. Not investing may be the riskiest move of all. _________________________________________________________________ _________________________________________________________________
Are there more investment risks you should be aware of? Absolutely. There are endless ways to make money, and it seems like there are even more ways to lose money. The best way to develop an understanding of investment risks is to keep learning. _________________________________________________________________
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