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This article talks about the benefits and risks of investing in the stock market to help you gauge, whether or not stock investing is right for you.
Investing in the stock market has its share of risks and rewards due to various factors and conditions. For instance, when trading conditions are favorable, investors earn excellent returns from their assets. However, when stocks go down in value during a market downtrend, investors may sustain losses.
Generally, there are two ways people “invest” in the stock market, some invest for long term asset growth, (buy and hold), while some try to buy and sell stocks on a daily basis (day trading). As an investor, I prefer the former because for me, investing in stocks isn’t about timing the market as no one can successfully do this, consistently, it’s about “time in the market”.
If you’re seriously considering stock investing as one of your wealth-building strategies, you have to acknowledge the fact that publicly traded stocks go up and down in value, such as the nature of the stock market, it’s called volatility and/or market fluctuation due to market supply and demand. What goes up, must go down but one thing you should take to heart is that the general trend of the market ever since it opened, is upward!
Proper understanding of the stock market will help you keep your peace of mind, sanity and assets, during market down trends.
Benefits of Investing in Stocks
Below are some advantages of investing in stocks and how it can potentially benefit your investment portfolio:
Asset Growth Through Investment Gains
As mentioned, the stock market’s general trend is upward so there’s always the potential of asset growth, which is the growth of the value of your stock portfolio if you’re investing in the long term.
Trying to turn stock investing into a source of income in the short term can be very risky, especially, if you don’t know what you’re doing.
If you want to invest in stocks, consider stock investing as part of your long term asset accumulation strategy to take advantage of compounded growth of your portfolio.
Asset Growth through Dividends
Some companies pay out dividends to stockholders, mainly when the company makes a profit. Some companies award their investors with other shares of stocks, annually irrespective of whether the firm is profitable or not. When you earn dividends, it’s a good idea to reinvest your dividends, this helps you boost your investment growth over time.
To mitigate your investment risk, it’s important to diversify your investments, stock investing, offer you the opportunity to diversify your portfolio by investing in different companies. If you’re investing in individual companies, diversifying your portfolio can be a pain and sometimes restrictive because you have to pick each individual stocks, equity funds, on the other hand, allow you to invest in shares of a portfolio with multiple stocks (and bonds) in it, which means, one equity portfolio is already diversified; if you invest in 3 or four equity funds, you’re further diversifying your risk, so all you have to do is to continue investing in your portfolios on a monthly, quarterly or annual basis.
Diversification entails investing in different assets to mitigate or spread your investment risk, so when one asset goes down in value, other assets may go up, or remain the same. Note that stocks change their values based on several factors, such as demand, supply, and the nature of the market.
Buying stocks means owning a part of the company you are investing in. By being an owner (sometimes, depends on the value of your holdings), you may be eligible to participate in an annual general meeting and make vital decisions regarding the company’s operations.
As part owner of a publicly-traded company, you also have the opportunity to earn dividends, as mentioned earlier and when your equity grows in value, you may be able to sell your shares for a profit later on.
Stocks are liquid assets, which means, you can turn them into cash any time you wish, unlike real estate which may take time before you’re able to cash-out, stocks can be sold and bought in a matter of minutes. Thanks to technological advancements that make all these possible.
Disadvantages of Investing in the Stock market
A stock market is an ideal place for investors like you to invest money for dividends and growth. However, there are disadvantages to investing in the stock market, and they are as follows:
As mentioned above, the prices and values of company stocks, go up and down due to a lot of factors like market volatility, supply and demand, economic and political issues, and company performance.
If the company you own through your stock portfolio performs poorly, other investors are likely to sell their shares, which leads to decline in value of your stock holdings; if you sell when the value of your stock is lower than your initial purchase price, you’re selling at a loss.
To mitigate against this risk, you have to buy right, by carefully choosing the companies you invest in; choosing unstable companies that may under-perform will devalue your investment, instead of growing its value; if you’re unsure, we can help you invest in managed portfolios, where you invest in portfolio funds, instead of individual stocks. Click here to request an appointment with our team.
3 Types of Risks Associated with Stock Investing
Before you invest in stocks, it is of crucial importance to understand the various risks associated with Investing in the stock market:
- Market risk
Market risk occurs when there is a decline in a stock’s value due to its supply being more than demand. This scenario can cause the value of your investment to go down over time.
- Inflationary risk
When inflation rises, it reduces the value of an asset and causes recessions. During such a time, the prices of stocks fluctuate and may have a lower value.
- Liquidity risk
Liquidity risk occurs when you are unable to dispose of your investment at a fair price according to your needs. In such circumstances, you may be forced to sell your stocks at prices lower than your expectations or you will have to wait until the value of your stocks reaches your target selling price.
Stockholders Paid Last
When you’re investing in individual stocks, and the company you invested in gets bankrupt, payments are first made to bondholders and preferred stockholders; ordinary shareholders are paid last, and they may fail to get what is due to them, in case the firm depletes its funds by paying everyone else.
You can mitigate this risk by investing in portfolios instead of individual stocks, so you’re not putting all your eggs in one basket. An equity portfolio has a mixture of stocks and bonds from multiple companies, sectors, and countries, thereby further diversifying your investments.
Investing in stocks can be time-consuming if you’re a self-directed stock investor. This is because you can’t just go out there and buy the first stock you come across or the stock that your truck driver buddy has been urging you to buy. You have to perform your own analysis and due diligence before pulling the trigger.
As a self-directed stock investor, you have to learn two types of analyses as follows:
As a self-directed investor, you have to learn Technical analysis, entails reading and understanding price charts, signals and candle-sticks, if this is you, and you don’t mind learning technical analysis, self-directed stock investing may be right for you.
Fundamental analysis is the monitoring and analysis of news and current events that may affect the trading price of the stocks you’re targeting to buy and ones you already have in your portfolio; this includes government, economic, and company announcements.
If this is the first time that you’ve heard of the terms technical and fundamental analysis or even if you’ve heard these terms before but never really ran any of these stock investing analyses, you’re fairly new to stock investing and as such, there is a learning curve to self-directed stock investing, as mentioned above, if you’re someone who’s serious about learning how to invest in stocks on your own, you have to be willing to exert the effort to learn the ins and outs of stock investing.
Below are some good stock investing books to help you get started:
- The Intelligent Investor
- How to Make Money in Stocks
- One Up on Wall Street
- A Random Walk Down Wall Street
- When to Sell
- Irrational Exuberance
- Stock Investing for Dummies
- Stock Investing for Dummies
- Stocks for the Long Run
- Market Wizards
Why Invest in the Stock Market?
Stock investing is not for everyone, in fact, there are a lot of other investment options available to anyone looking to build wealth; there’s real estate, bonds, mutual funds, segregated funds, ETFs, index funds or even the plain old bank savings account, which may not get you very far.
Choosing your wealth accumulation vehicle all depends on your preference, skill and/or time availability.
Generally, one of the most important reasons why people invest in the stock market is compounded growth.
Investing in the stock market can help you grow your money through the power of compounding growth.
For instance, if you invest $5,000 today, and it gains 8% per year, your investment will have doubled in amount in 10-years.
This, of course, is just an example, your investment growth will depend on the actual performance of your portfolio.
Based on the historical performance of the stock market, though volatile, the general trend is always upward, so if you’re investing for the long-haul, you could expect your money to grow compounded over time.
Some people prefer the safe and secure haven of a GIC or a savings account due to the volatile nature of the stock market and other related investments. Holding your money in cash makes it lose its value over time due to inflation; the average annual inflation rate in Canada is 2.27%, if you’re holding your savings in cash, and isn’t growing them, you’re losing 2.27% in inflation every year.
Instead of holding your money in a savings account or GIC, investing them can give you compounded growth over time.
If you’re thinking of investing in individual stocks, keep in mind that picking individual stocks as a self-directed investor can be tricky, and has higher risk than managed and portfolio investments; as mentioned above, picking individual stocks requires a good amount of skills, specifically technical and fundamental analyses of the stock market or each individual stocks you’re looking to invest in.
If you don’t have the time or skill to learn stock investing and to research and monitor stock prices, I would suggest that you take a look at portfolio investments like mutual funds, segregated funds, or index funds and invest passively.
Managed funds and index funds take away the excitement in investing but does allow your assets to grow steadily over time, which may give you similar effect than when you’re trying to pick individual stocks on your own.
What are the Factors to Consider When Buying Stocks?
Buying stocks isn’t anywhere near to buying shoes, purse or your next gadget; while proper research and due diligence may have been taken whenever you find yourself longing for these material possessions, there are more important factors that come into play when considering investing in individual stocks, some worth mentioning are as follows:
The Company’s Debt-to-Equity Ratio
Almost all companies have liabilities in their balance sheets, and it is vital to analyze various firms to select the ones with more assets than liabilities. Therefore, if you are looking for low-risk investments, consider businesses with a debt-to-equity ratio of less than 30%. This means that a company’s debts shouldn’t go beyond 30% of its total equity.
This ratio is based on the company is market price and its earnings per share. Note that the higher the price-earnings ratio, the higher the likelihood of your investment growth.
Consider investing your money in companies that pay modest but consistent dividends over time. A stable company is the one that balances between paying dividends and investing its earnings in other firms.
A company that is led by competent managers is likely to perform well in terms of profitability. Before you buy shares, investigate the firm’s culture, level of innovations, and the latest reviews.
Growth in Earnings
The net gain in the company’s income over time determines its growth in assets. It is advisable to invest in firms whose revenues have been steady for some time.
How to Reduce Risk in Investment
Understanding different types of risks and how to mitigate them is essential for any investor. I really, you should diversify your investments. Most self-directed investors only invest in a handful of companies when investing in individual stocks. Investing in an equity or portfolio fund helps you diversify your risk right from the get-go.
Here is a list of what you should do to minimize your risk investment risks if you’re picking individual stocks:
Do your due diligence before you invest
Analyze various aspects, such as management, earnings, debt load, before you make any step to invest.
Diversify your investment portfolio
With diversification, your overall risk is minimized since it is spread over many assets, one way of doing this is by investing in equity or managed portfolios where one portfolio contains various stocks and bonds. We can help you set a tax-deferred or tax-sheltered managed investment portfolio through segregated funds, click here. to book an initial consultation.
Regular monitoring of your investment
Proper allocation depends on your age, investment period, and the level of your needs. Therefore, you need to evaluate your investments annually to determine whether to sell or buy to rebalance your portfolio.
Stocks vs. Bonds
Understanding the differences between stocks and bonds will help you make a well-informed decision on choosing your investment portfolio, as a well-balanced portfolio that matches your risk tolerance is essential in mitigating risks while achieving your long term investment goals.
Below are highlights of the differences between stocks and bonds:
- Bonds, which are otherwise called “Income Funds” are debts, so when you “buy bonds”, you’re technically buying government and corporate debts which are expected to give lower but more consistent yield compared to stocks.
- Stocks, on the other hand, are stakes of ownership in a corporation.
- The returns on stocks are dividends that are payable based on the company’s performance but not guaranteed. However, the yields on bonds are fixed and payable irrespective of the company’s performance.
- Stocks are usually issued by different firms while bonds are issued by corporate entities, governments, or financial institutions
- Stockholders are regarded as owners of the company, and they enjoy voting rights. However, bondholders are treated as lenders to the firm; hence they are not accorded benefits, such as voting rights.
Investing in the stock market, just like any other investments, has its own risk and rewards.
Self-directed investing can give you a lot of benefits if you know how to analyze and reduce your risks in stock holding but it can also lose you money fast if you don’t know what you’re doing.
Investing in the stock market doesn’t mean that you should invest 100% of your portfolio in stocks, there are ways on how you can minimize your investment risks, like investing in managed or portfolio funds which are already highly-diversified or manually mixing your portfolio with bonds or income funds.
Whether you’re investing in individual stocks or in portfolio investments, it’s important to understand that stock and investment prices go up and down and sometimes, you may find yourself with a negative asset portfolio; this does not mean however that you’ve already lost on your investment; as long as you stay invested, you still haven’t lose any money yet.
What’s important to keep in mind is to know what your investment profile and risk tolerance are and that you’re investing for the long term. Trying to maximize your returns in the short term will do you no good as it will lead to being aggressive with your stock picking. The best way to take advantage of the market is to ride that market, the longer time you spend in the market, the higher your compounded return will be.
When investing, don’t just invest in stocks, shoot for a mixture of stocks and bonds as bonds will help you minimize your loses in case of market downtrends.
There are various ways on how you can invest in the stock market. If you want to control over your investing and you don’t want to pay management fees to portfolio managers, you can be a self-directed investor and pick your own stocks, or you can ride the market through index funds and ETFs.
If you’re someone looking for guarantees, credit and probate protection for estate planning or security purposes and you don’t mind paying professionals to manage your investment, segregated funds may work for you.
Whichever way you want to start investing in the stock market, you have to start as soon as possible to take advantage of your time horizon. The longer time you have, the more your asset will grow!