How to reduce the risk by investing in the stock market?

Each investor has a developed strategy, according to which he moves on the market. It has been known for a long time that all forms of investing capital in assets with a higher rate of return are in a way related to taking a higher level of risk. So how to reduce the risk by investing in the stock market?

It does not have to be that it is inseparably connected only with the stock exchange. Therefore, a good investment plan should take into account several key parameters, which will also positively affect the rate of return on capital employed in the long run. I encourage you to read a few simple tips that may prove useful, especially at the beginning of our investment journey.

Diversify

This concept has probably also appeared many times in articles on investing capital, for example in investment funds or directly saving. diversification is the key word in risk management. You shouldn't bet everything on one card on the stock market. Contrary to appearances, even a good company can expose us to unnecessary risk. If we have securities of only one company, a decrease in their value by 50% for us is tantamount to a loss of half the value of the portfolio. If, for example, we had 10 companies (with an equal share) and one of them recorded the above-mentioned decline, our finances would suffer 5%. There are several basic ways to diversify. The first one is, of course, the non-involvement of all accumulated capital in one enterprise. Even on the "occasion" of an investment and a very undervalued company, one should take into account the risk margin that we place on our own money.

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What, however, when we have a small capital and shredding it does not make much sense because of the commissions? We can safely accumulate additional capital for several months to increase our exposure to the market. What's more, stuffing a large number of companies into the portfolio also does not make sense. If we look at the portfolios of big players, they own several companies. Therefore by purchasing shares in 15 different companies there is a much greater chance that our rate of return on investment will be much lower than by buying shares in the 3 largest companies.

Of course, there is the concept of over-diversification. Experienced stock market investors recommend having as many companies that we are able to monitor and analyze on an ongoing basis.

Don't invest in one industry

We know that it is not worth overdoing the number of companies that we want to buy as part of diversification. Going to the other extreme and stubbornly sticking to the shares of only one company is also not the most reasonable solution, given the constantly changing stock market conditions and dynamic economic environment. Another important factor that reduces the investment risk is the avoidance of those from the same industry when expanding the portfolio with new companies.. If the prices of, for example, building materials on the global market increase, the main losses will be the development and construction sectors, for which it will also mean increased costs of materials that are needed in the construction process.

The company's securities will also follow worse margins and similarly worse results. Therefore, even temporary weaknesses of companies from one or similar industries may be significantly discounted. A helpful tool in finding opposing industries can be tables correlationwhich show how much (or not) enterprises from a given industry are “related” to each other. A very general rule is that the smaller the values ​​of the correlation coefficient of two companies (approx. 0,2 - 0, they can be negative), the less they are related to each other. Consequently, they are more attractive than enterprises whose correlation coefficient is, for example, 0,80. This number proves a similar behavior of their quotations. Therefore, there is a good chance that both companies operate in similar or the same industries.

Avoid one type of financial instrument

The stock exchange is not only the stock market. It consists of, among other things bond market and derivatives. Depending on the stock market situation, it is worth having different investment assets. It is known that everyone would like to have a portfolio full of good stocks during a bull market, and during a bear market, they would rather not have them at all. Consequently, how could we deal with this issue? It is of course important to be aware of the current market situation. Nevertheless, it is worth having a balanced portfolio of various instruments. Here, too, you should do it wisely, so as not to be divided into several dozen different forms of investment. It helps, of course investment strategywe use. If someone trades on companies hoping for a quick increase in their value, he will probably not worry about temporary weaknesses in the market. On the other hand, if we are an investor who invests capital hoping for a long-term increase in the value of shares, during the bear market we will rather focus on buying cheap securities.

Limit your losses

Not being able to quickly close losing trades is the most common mistake made mainly among beginners (and not only) investors. This is essential from a purely arithmetic point of view. If, for example, we lose 10% of our investment, we have to make up 11,1% to gain initial capital. Here the difference seems to be small. However, already at a loss of 30%, you should run a profitable position so that it brings you to 42,9%, to reach the proverbial zero. The conclusion is therefore quite trivial. Quick loss cuts = easier to make up for lost cash. Here, too, proverbial speaking, the question of the strategy used, which we developed a point above, bows.

Prepare carefully for your investment

Generally, the more you know about the instruments you invest in, the better. Learning, constantly improving our skills or improving our strategies increases our chances of success and reduces exposure to unnecessary risk. Any investment decisions we make should be based solely on our own analysis. Beginning investors very often have the first contact with the stock market when buying a given item on the recommendation of a brokerage house. I am not saying that the recommendations of analysts or more experienced colleagues or financial institutions are bad. Their essence, however, is a subjective view of the market.

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Therefore, if we want to be strictly guided by recommendations, we should take them a bit at a distance and try to get to know the company we want to buy, at least to a small extent. Why? Mainly for purely "technical" reasons. When buying security we rely on some advice. If it is conscientiously depreciating, most of us will not be able to close the losing position due to the fact that we are unable to make our own decisions. The second important point - analysts are also people. They are necessarily wrong and they make mistakes.

Don't take risks for nothing

If you are in doubt as to whether or not to engage in an instrument, it is known that it is safer to withdraw. Sometimes the lack of a transaction turns out to be the best deal. It is always worth calculating your decisions in terms of the risk taken to the expected profit. This is, of course, a very general determinant of value. You may find it helpful to answer some basic questions: how well do i know the company? I know how it deals with debt and liquidity? does he have a good managerial staff? I know and use her products? do I know what business model is used? If the answer to most of your questions is "don't know" or "no", I don't think it's worth investing unnecessarily.

The second point is the purely mental aspects. It is known for a long time that the situations in which we are unable to rationally explain certain phenomena, they cause us nerves and stress. In addition, there is the material aspect, where in addition to the lack of the ability to think rationally, we are influenced by, for example, the increasing loss on the papers of our perfectly selected company.

Order in your own finances

The risk does not come from the market alone. Often from our conduct or from a bad approach to personal finances. Before starting any investment, it is worth considering how much we are able to "spend" at the beginning. If this is an amount that, when adding the commission for opening a transaction at the start, will result in a few percent in the minus, there is no point in investing capital. Sometimes it is worth forgetting about investing money in "great deals" and collecting it a little more on the bill. This is where simple math and rational assumptions about investment return are bowing.

Only invest the surplus, avoid loans

Investing financial surplus gives us great psychological comfort. As a surplus, we should understand money that we do not need at present and that the potential loss will not cause in our budget, mixing current expenses with investment decisions. It has to be an amount that we will not need 100% in our daily operations. This significantly facilitates capital management in view of long-term keeping of securities in the account. Importantly, it allows you to go to sleep without the need to monitor the quotes 24/7.

Now let's move on to discussing credits. On brokerage accounts it is possible to take them out for investments, of course. Of course, borrowing is not a bad thing. On the contrary, commitments taken wisely and moderately, and acted carefully, can increase our commitment to a worthwhile investment. Nevertheless, at the beginning it is worth considering whether we will be able to pay them off and how they will affect the profitability and the amount of capital involved.

Financial pillow

It is worth mentioning briefly that you should not invest 100% of all your savings on the stock exchange. Specialists involved in the study of personal finances attach great importance to the diversification of the money set aside. However, the issue of risk appetite should be emphasized here. If we are actually not afraid (we can manage them!) Of losses and want to obtain potentially higher profits in return for greater risk, our portfolio will be more rich in stocks than a person who has kept funds in a bank deposit all his life. A financial cushion is a certain amount of savings that we are able to quickly and without losses when they are necessary for our daily functioning. It should be 3-6 times our monthly salary.

Summation

Merely knowing the risk is essential in making investment decisions. In addition to being aware of its existence, the ability to minimize it and consciously manage potential losses is essential. In theory, everything seems relatively simple and easy to apply. The problem arises when it is necessary to actually implement strictly defined measures into the investment life. It requires self-discipline and sticking to the plan.