Investing is one of the best possible ways to build wealth. When you buy stocks and other investment vehicles, you give your money the chance to work for you. With the power of compound interest on your side, you could see your nest egg grow larger, helping you avoid the losses you’d see from inflation if you kept your money in cash. However, none of this means that losses do not occur in investing. On the contrary; investing comes with significant risks. However, many ways to manage risks when investing exist. Here’s what you need to know.
How Risks Work in Investing
When companies issue stock, they offer shares in their company in exchange for cash. They invest that cash, and everyone wins, if they’re lucky. The company gets to grow and increase in value, thanks to its cash injection. The increased value of the company means that each share, including the ones that the original owners still hold as well as the ones that new investors have purchased, is now worth more. Investors can then sell the shares for a profit, if they wish.
Shares can keep getting traded after that, of course, and the merits of the companies behind the stock always matter to investors. A share’s appeal to investors is what determines its value. The “share price” is just the price at which people wish to buy the stock. It’s all supply and demand!
In other words, if nobody in the marketplace wants to buy a stock, its price starts to fall until it’s discounted in the appropriate manner. This can happen for all sorts of reasons. Maybe the company just got a bad earnings report. Maybe a new technology is rendering the company’s product obsolete. Stocks can go down!
Volatility and Risk
Stocks can indeed fall, but not all stocks prove equal risks. A few factors can help us predict how volatile a stock is. For instance, very small companies with cheap stock–“penny stocks”–is volatile, because the small number of buyers and and sellers of such stocks makes the supply and demand much more prone to statistical noise. Buy shares of a startup for cheap, and you might find that they go out of business. Or, you might end up buying the next Apple. Volatility means risk, but also potential riches–high risk high reward stocks, if you will.
Balancing Risk in Your Portfolio
So, how can you make money on the stock market without being overcome by risk? The answer is in diversity.
A diverse portfolio of stocks is just that: a portfolio that contains many different stocks. The more stocks you own, the less you rely on individual companies’ performance. Therefore, the less at risk of problems with one stock you become.
Of course, it also matters which stocks make up your portfolio. You should consider investing in a number of safe companies–”blue chip,” in investor parlance. Or, invest in index funds that track major indices, like the S&P 500. Index funds create diversity for you by tracking the value of a bunch of different stocks at once. Since the S&P 500 is a list of large companies, many safe bets exist in there. There are also many emerging markets such as medical marijuana stocks and cryptocurrencies that can be worth researching.
That’s not to say that you should take no risks. You’ll have a chance at more aggressive growth if you also buy riskier stocks. The conventional wisdom says that younger investors should be more aggressive than older ones, and then get a bit safer as they near retirement. Investment funds that will do this for you also exist, and target date funds from many major brokerages can simulate this all in one simple fund.
In short, you can, and should, invest without fearing inordinate risk. By holding a diverse portfolio and making sure that a good chunk of your investment is in safe bets, you can enjoy growth and pursue riskier investments without putting your future at risk.