Investing for Beginners
Let’s review some of the basics of investing, starting with a brief discussion of return and risk, and how these two factors should be the basis for most investment decisions. Next, we’ll talk about risk types that exist when investing in the stock market. In the end i’ll provide you with some suggestions that allow beginners to participate in the stock market while minimizing risk.
Balancing Risk and Reward
Most beginners think about moving their money from safer investments (such as money market accounts), into riskier securities (such as common stocks), because they believe (and rightfully so) the stock market offers them a chance for higher returns on their investment.
Recognizing the relationship between reward and risk is a good sign. There are losers and winners in the stock market every trading day. But the long-term rewards associated with the stock market are higher than safer investments (such as bank accounts). The lesson here is simple: Greater investment rewards do come with greater risks.
Risks are taken by the people all the time, and most of these are “calculated risks”. After carefully evaluating a situation, the decision is made based on the assessment of the rewards and risks involved.
This same concept applies to the common stock of companies and the stock market. Generally, there are two types of risks an investor will encounter: individual company risk and market risk.
Every stock market investor is exposed to market risk. This is the large scale risk that the entire market either moves down or up. These movements may be due to external factors such as international interest rates or political events. There is very little an individual investor can do about market risk.
An industry risk is a refinement of market risk, whereby all companies in a certain industry experience a downturn in their outlook. An individual investor has some control over industry risk because they can steer clear of certain industries especially if the investor is selecting individual stocks. Unfortunately, a second risk comes into play by selecting individual companies: The risk that the company selected will falter.
Individual Stock Risk
The good news here is that there is something investors “can do” about the risk of an individual company. By investing in a number of stocks (generally ten or more companies), this risk can be easily mitigated, as it insulates the total investment from individual company risk by creating a portfolio. So if one of the selected companies underperforms relative to expectations, there is a chance that another company will outperform expectations.
There are two ways to build a stocks collection that can effectively lower an investment’s exposure to individual stock risk. An individual can buy into a stock portfolio that has already been created or create a stock portfolio by himself. Both of these options lowers the overall investment risk by offering diversification.
Creating an Investment Portfolio
Most beginners do not have enough money to efficiently create a stock portfolio. Also, for someone that’s just starting out its not such a good idea to create a portfolio. There is simply too much information to learn before taking such a big step. Instead, beginners may be better served by buying into a stock portfolio assembled by a professional.
A more efficient investment approach is buying shares in a mutual fund, which offers investors several significant advantages including:
- Diversification: a mutual fund is a portfolio of bonds, stocks, and other securities that are sliced thinly and sold to individual investors. It’s possible to buy a slice of a mutual fund, with as little as $1,000.
- Flexibility: investors can sell and buy fund shares by telephone, over the Internet, or even using the United States Postal Service.
- Selection: an individual can choose from literally thousands of mutual funds, many tailored to the specific needs of certain investors.
- Expert Management: most beginners are simply not equipped to forecast future earnings per share or prices of individual companies. A mutual fund pays a professional fund manager to perform this duty.
If an investor wants to enjoy higher returns, they need to take greater risks. While general economic conditions threaten all holders of common stock, there are some risks that can be controlled. Mutual funds provide investors with a great introduction to the stock and bond markets, while allowing them to leverage the expertise of the fund manager.