Risk and reward are inextricably intertwined, and therefore, risk is inherent in all financial instruments. As a consequence, wise investors seek to minimize risk as much as possible without diluting the potential rewards. Warren Buffett, a recognized stock market investor, reportedly explained his investment philosophy to a group of Wharton Business School students in 2003: “I like to go for cinches. I like to shoot fish in a barrel. But I like to do it after the water has run out.”
Reducing all of the variables affecting a stock investment is difficult, especially the following hidden risks.
Sometimes called “market risk” or “involuntary risk,” volatility refers to fluctuations in price of a security or portfolio over a year period. All securities are subject to market risks that include events beyond an investor’s control. These events affect the overall market, not just a single company or industry.
They include the following:
Volatility does not indicate the direction of a price move (up or down), just the range of price fluctuations over the period. It is expressed as “beta” and is intended to reflect the correlation between a security’s price and the market as a whole, usually the S&P 500:
According to Ted Noon, senior vice president of Acadian Asset Management, implementing low-volatility strategies – for example, choosing investments with low beta – can retain full exposure to equity markets while avoiding painful downside outcomes. However, Joseph Flaherty, chief investment-risk officer of MFS Investment Management, cautions that reducing risk is “less about concentrating on low volatility and more about avoiding high volatility.”
Strategies to Manage Volatility
Strategies to reduce the impact of volatility include:
Market pundits claim that the key to stock market riches is obvious: buy low and sell high. Good advice, perhaps, but tough to implement since prices are constantly changing. Anyone who has been investing for a time has experienced the frustration of buying at the highest price of the day, week, or year – or, conversely, selling a stock at its lowest value.
Trying to predict future prices (“timing the market”) is difficult, if not impossible, especially in the short-term. In other words, it is unlikely that any investor can outperform the market over any significant period. Katherine Roy, chief retirement strategist at J.P. Morgan Asset Management, points out, “You have to guess right twice. You have to guess in advance when the peak will be – or was. And then you have to know when the market is about to turn back up, before the market does that.”
This difficulty led to the development of the efficient market hypothesis (EMH) and its related random walk theory of stock prices. Developed by Dr. Eugene Fama of the University of Chicago, the hypothesis presumes that financial markets are information efficient so that stock prices reflect all that is known or expected to become known for a particular security. When new data appears, the market price instantly adjusts to the new conditions. As a consequence, there are no “undervalued” or “overvalued” stocks.
Coping with Timing Risk
Investors can mollify timing risks in single securities with the following strategies:
Many successful people reject the possibility of luck or randomness having any effect on the outcome of an event, whether a career, an athletic contest, or investment. E.B. White, author of Charlotte’s Web and a longtime columnist for The New Yorker, once wrote, “Luck is not something you can mention in the presence of a self-made man.” According to Pew Research, Americans especially reject the idea that forces outside of one’s control (luck) determine one’s success. However, this hubris about being self-made can lead to overconfidence in one’s decisions, carelessness, and assumption of unnecessary risks.
In October 2013, Tweeter Home Entertainment Group, a consumer electronics company that went bankrupt in 2007, had a stock price increase of more than 1,000%. Share volume was so heavy that FINRA halted trading in the stock. According to CNBC, the reason behind the increase was confusion about Tweeter’s stock symbol (TWTRQ) and the stock symbol for the initial offering of Twitter (TWTR).
J.J. Kinahan, chief strategist at TD Ameritrade, stated in Forbes, “It’s a perfect example of people not doing any homework whatsoever. Investing can be challenging, so don’t put yourself behind the eight-ball to start.” Even a cursory investigation would have informed potential investors that Twitter was not publicly traded, having its IPO a month later.
Stock market success is the result of analysis and logic, not emotions. Overconfidence can lead to any of the following:
Strategies to Stay Grounded
Strategies to reduce the impact of overconfidence include:
“It’s not what you make, it’s what you keep that matters.” The source of this widely recognized quote is uncertain, but it can be found in almost every list of famous quotes about the stock market. The saying illustrates the need to reduce risk as much as possible when investing. Achieving significant stock market gains, only to lose them when a disastrous event occurs, is devastating – and often unnecessary.
Robert Arnott, founder of the Research Affiliates asset management firm, identified the dilemma in the relationship between risk and return: “In investing, what is comfortable is rarely profitable.” By employing some of these strategies, such as dollar-cost averaging, reducing portfolio volatility, and diversification, you can protect your wealth and sleep better at night.
Are you concerned about the risks in the stock market? What steps do you take to reduce your exposure to negative events?
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