Understanding Investment Risks In The Financial Markets

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Understanding Investment Risks In The Financial Markets by Goal Investor

Do you go without health or homeowner’s insurance in order to save money? Do you go to casinos and play the slot machines? Ride a motorcycle without a helmet? Most of us understand that these are frivolous, high-risk practices that can cause grave harm. But do you know the risks involved in investing?

Investing in the financial markets can also be a high-risk practice, but it doesn’t have to be. And, when done responsibly, it’s not frivolous and it’s much more likely to help you than hurt you. In fact, it’s the best way to save money for long-term goals like retirement or your children’s college education.

When you invest, you decide how much risk you want to take on and how to manage that risk over time. Low-risk investing will give you low but dependable returns. High-risk investing can give you high returns. Or it can wipe you out.

Risk comes in many forms. The most obvious is that your investment will lose value. But there’s also:

  • Opportunity risk: You choose one investment over another, and the one you rejected ends up doing better than the one you chose.
  • Market risk, also known as systemic risk: A crisis may hit the markets and cause virtually everything to drop in value.
  • Risk of missing your goal: Having invested too conservatively or for too short a period, your investments are unlikely to grow enough to meet the goal you’ve set.

One thing you can count on: if it seems too good to be true, it is. There is no such thing as a low-risk, high-yield investment – unless you get very lucky.

For decades, the stock market has operated according to the “efficient market theory.” It holds that information about stocks is equally and simultaneously available to everyone who buys and sells them. Therefore, it’s impossible to beat the market by knowing something that no one else knows, unless you’re trading on inside information, which is illegal.

Recent events in the stock market – the crash of 1987, the bursting of the tech bubble in 2000 and the 2008 financial crisis – have led the high priests of finance to think that maybe the markets aren’t so efficient, after all.

What has come to compete with efficient market theory, if not replace it altogether, is the science of behavioral finance. Its basis is that many people make investment decisions for less-than-rational reasons, such as recent experience, overconfidence or personal bias – like betting on a racehorse because you like his name – instead of an unbiased analysis of objective market information.

Proponents of behavioral finance theory say that irrational investment decisions by poorly-informed people can lead to stocks being overvalued or undervalued.

Some common examples of bad investing strategy that behavioral finance theorists point to:

  • Buying a lot of stock in the company that employs you. The fact that you work there and like it is not a good reason to buy its stock. Yet, a lot of people do this. Employees of Enron and MCI learned this lesson the hard way.
  • Buying stock in a local company because it’s familiar to you. Having a good feeling about a company that’s an important part of your community doesn’t make it a good buy. If you live in Detroit and own GM stock, or if you live in San Francisco and loaded up on tech stocks in the late ‘90s, you already know this.
  • Jumping on the bandwagon of an asset class that’s been going up in value, on the assumption that it’s going to keep going up. “When an asset class has recently done well, investors pile in, frequently investing before a period of below-average returns,” says University of Florida finance professor Jay Ritter.That happened with tech stocks in late 1999 and early 2000, and with real estate in 2005-2006.During a long bull market, such as occurred in the ‘90s, less-experienced investors tend to think that bull markets are the norm.

    Some more-experienced investors seem to think that, too. In October 1999, the book Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market was published. A few months later, the Dow Jones Industrial Average fell from 11,723 to 8,322 (29 percent) and the NASDAQ stock exchange plunged from 5,049 to 1,210 (76 percent).

  • Overconfidence. Diversification is a crucial part of any investing strategy, but overconfident investors often put all their eggs in one basket. If their investment goes south, they can lose it all.They also tend to trade more often than they should. A 2001 study of investors with discount brokerage accounts found that the more they traded, the worse they did.It also found that men traded more often than women. Consequently, men’s net returns were reduced by 2.65 percent per year, as opposed to 1.72 percent for women.[1]
  • Impatience. Inexperienced investors tend to look at their investments over periods of weeks or months, lose patience with those that haven’t performed well, sell them and buy assets they think will do better. In addition to the costs of buying and selling securities, impatient investors rob themselves of the long-term growth potential of their investments.Ignoring fees. Sales commissions and other fees can eat away at any investment gains you make. A lot of investors fail to take this into account.

So, here are some simple things you can do to reduce your exposure to risk:

  • Diversify. Spread your money around so that if one of your investments goes bad, others won’t. For example, when stocks go down, bonds usually go up, and vice versa.
  • Build a good investment strategy for your goals and leave the money alone. Selling one security and buying another that seems to be doing better is usually a mistake. You’ll pay commissions on the sale and the purchase and maybe other fees, as well. Be patient. Measure your investment’s performance over the long-term, and pay more attention to whether you’re on track to achieve your overall goal than to whether you’re beating some industry benchmark. Don’t get frustrated by a short-term loss.
  • Don’t go heavy on the stock of the company you work for. The fact that you like working there doesn’t mean the stock is going to go up.
  • Don’t think you know something that no one else knows. If you come across a company whose stock looks like a good buy, rest assured that other people have already discovered it, bought the stock, and the price is changing accordingly.
  • Never invest without fully understanding the costs. How much is the sales commission, if there is one? What fees will you pay over the course of the investment? Is there an early-withdrawal penalty?

Following these rules of thumb won’t insulate you from risk, but it will markedly reduce the chances of your being burned.

This information is provided for education purposes only and is not intended to provide investment advice. SEI does not claim responsibility for the accuracy or reliability of the information provided. 

[1] “Boys will be Boys: Gender, Overconfidence, and Common Stock Investment,” Brad M. Barber and Terrance Odean, U. Cal., in Quarterly Journal of Economics.

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