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Individuals who want to invest in equities need to understand the risks associated with investing. Investing in shares can be highly lucrative and can set you up for a bright financial future. However, understanding the risks and benefits associated with buying shares is a crucial step for your education.
Investing in shares, like any investment, comes with a certain amount of risk. Shares are often described as 'high-risk asset classes' when compared with other types of investments. The primary risk of investing in shares is that it can result in a loss of capital.
Unexpected events outside of your control or negative developments within the company can significantly affect share prices and the value of your portfolio. In saying that, this is not to scare you away from investing in shares, but merely a necessary understanding that all investors must-have.
There are ways to reduce the risk associated with investing in shares. The following are common measures that investors should have in place to control the risks associated with buying shares. Keep in mind that this is general advice only and may not be suitable for your personal circumstances.
Not having all your eggs in one basket is a motto that strongly applies when it comes to buying shares (famous words by Warren Buffet). Probably the worst mistake a new investor can make is to not diversify adequately. Diversification refers to making sure an investor has shares in several companies of different industries/sectors/countries etc., thereby reducing the risk relative to the return.
The degree of diversification is to the discretion of the investor. For example, if you decide to invest your entire portfolio in a single company dominated by the oil price, a collapse of the oil price will result in a collapse of your entire investment. Hence why it is important to diversify across different industries. Diversification on the share market can take many forms, for example investing in different sectors or different countries or both.
For example, a well-diversified portfolio may have exposure to Telecommunications, Materials, Financials, Consumer Staples, Information Technology and International, just to name a few.
The difficult part is knowing which sectors are most suitable and more importantly which companies within the sector are suited to your investment goals. One of the problems that often arise with diversification is that investors diversify at the cost of understanding their investments. Diversification is an important step when building your own portfolio.
It is vitally important to understand the company you are buying a share of. These days many investors forget that when they buy a share they are actually buying a part of a business and not just a digital ticker code. Without fully understanding the company's operations, its financials or future outlook it is very hard to determine if it will be a good investment.
The problem arises when you are interested in a firm, however, you are unable to fully understand its business model. In order to diversify adequately, you may be forced to look outside your scope of understanding. If you don't have the time or expertise on how to analyze companies a finance professional may come in useful. Having a professional equity analyst to contact and discuss the company will potentially lead to better investment decisions.
Different strategies can lead to success, however, in Wise-owl's view investors have the greatest chance to succeed in the stock market by taking on a long-term approach. An investor’s holding period (how long the investor plans to hold the shares) is crucial when it comes to investing. The shorter the investment horizon, the harder it is to predict the direction of the stock.
Market fluctuations are regular, mostly unprovoked and are hard to predict. A common mistake among investors is to sell after a fall and buy after a rise. This results in complete absorption of the fall and missing out on the rise. The rule of thumb is don’t try and time the markets, have long term outlook and invest in good companies.
Emotions are likely the number one challenge investors face on a day to day basis. Media speculation, your Barber’s stock tips, fear of missing out or running with the crowd are all factors that affect our emotions and in turn our investment decisions.
Removing emotion from your investment decisions is easier said than done however having an investment strategy and the discipline to stick to it, can reduce the risk of emotional decision making.
Now that we have spoken about the risks associated with investing and how to reduce them, we will analyze the benefits of investing. There are several reasons why an individual chooses to invest in the stock market.
There is hardly any other investment vehicle that facilitates such a diverse set of objectives like the equity market. The stock market facilitates investors from all geographies and all investment styles. The following is just some of the main benefits of investing in shares:
Over the long term, shares have outperformed every other investment vehicle including property, bonds, cash and several others. We emphasize that this is over the long run as shares do fluctuate more than most other investment vehicles.
If you are unlucky with your timing or stock pick you might not outperform, however in the history of the stock market shares have increased in value despite several bear markets or 'market crashes'.
Some shares also provide income by the way of dividends. Dividends are the shareholder's portion of the company’s un-retained earnings. Dividends are generally paid by larger corporations with an established income profile and years of reliable earnings.
Most companies pay out a certain percentage of their earnings through dividends, which means that the net payout will grow if earnings grow. Dividends can be received in cash, by cheque or be reinvested in the company, also known as a 'Dividend Reinvestment Plan.'
Shares are more liquid than other investment vehicles. When we refer to liquidity we basically make reference to how easily an investor can find a buyer or seller for a transaction. The largest companies listed on the respective stock exchange offer the average investor with enough liquidity to buy and sell shares instantly.
This provides investors with the flexibility to use their funds where they see fit. It is important to remember that transactions are subject to brokerage fees and need to be incorporated into your calculations. Smaller companies also known as small-capitalization stocks may not offer enough liquidity to allow instant transactions on a daily basis.
Stock markets provide investors with the opportunity to gain exposure to several sectors and markets. For example, a young couple with their entire savings invested in property will only have exposure to the property market.
If the property market declines, the young couple will be fully exposed to the decline. Whereas a young couple with a diversified share portfolio can have exposure to several sectors and markets and can therefore reduce the impact of a sector-specific risk.
The most important point to remember is that there is no secret to successful investing. The only rule is to buy great companies and buy them at the right price. This has over time been a proven way to achieve success on the stock market. Being aware of the risks and rewards of investing in the stock market is crucial for the decision-making process. There are basic principles that allow you to minimize the risk of investing as outlined above, however, there is no way to completely remove risk.
Investors hoping to maximize their gains try to identify stocks that are mispriced, creating long opportunities for under-priced companies and short opportunities for overpriced shares. Not everyone believes a stock can be mispriced, particularly those who are proponents of the efficient markets hypothesis. Efficient market theory assumes that market prices reflect all available information regarding stock and this information is uniform. Such observers also contend that asset bubbles are driven by rapidly changing information and expectations rather than irrational or overly speculative behaviour.
Many investors believe markets are mostly efficient and some stocks are mispriced at various times. In some cases, the entire market can be pushed beyond reason in a bull or bear run, challenging investors to recognize the peaks and troughs in an economic cycle. Information on a company might be overlooked by the market. Small-cap stocks are especially prone to irregular information because there are fewer investors, analysts, and media sources following these stories. In other cases, market participants may miscalculate the magnitude of news and temporarily distort a stock’s price.
These opportunities can be identified through several broad methodologies. Relative valuation and intrinsic valuation both focus on a company’s financial data and fundamentals. Relative valuation employs a number of comparative metrics that allow investors to evaluate a stock in relation to other stocks. Intrinsic valuation methods allow investors to calculate the value of an underlying business independent of other companies and market pricing. Technical analysis allows investors to identify mispriced stocks by helping them to identify likely future price movements caused by the behavior of market participants.
Financial analysts employ several metrics used to relate price-to-fundamental financial data. The price-to-earnings ratio (P/E ratio) measures the price of a stock relative to annual earnings per share (EPS) generated by a company, and it is usually the most popular valuation ratio because earnings are essential to determine the actual value the underlying business provides for earnings. The P/E ratio often uses forward earnings estimates in its calculations because prior earnings are theoretically already represented in the balance sheet. The price-to-book (P/B) ratio is used to show how much a company’s valuation is generated by its book value.
P/B is important in the analysis of financial firms, and it is also useful for identifying the level of speculation present in a stock’s valuation. Enterprise value (EV) to earnings before interest, taxes, depreciation and amortization (EBITDA) is another popular valuation metric used to compare companies with different capital structures or capital spending requirements. The EV/EBITDA ratio can help when evaluating firms that operate in different industries.
Yield analysis is commonly employed to express investor returns as a percentage of the price paid for a stock, allowing the investor to conceptualize pricing as a cash outlay with potential for returns. Dividends, earnings and free cash flow are popular types of investment returns and can be divided by the stock price to calculate yield.
Ratios and yields are insufficient to determine mispricing by themselves. These numbers are applied to relative valuation, meaning investors must compare the various metrics among a group of investment candidates. Different types of companies are valued in different ways, so it is important for investors to use sound comparisons. For example, growth companies typically have higher P/E ratios than mature companies. Mature companies have more modest medium-term outlooks and also typically have more debt-heavy capital structures.
The average P/B ratio also varies substantially among industries. While relative valuation can help determine which stocks are more attractive than their peers, this analysis should be limited to comparable firms.
If you want to learn more about this, you can always become a part of Swastika Investmart’s Financial and Market Research (SIFMR). Click here to join us.
Some investors ascribe to the theories of Columbia Business School’s Benjamin Graham and David Dodd, who contend that stocks have an intrinsic value independent of the market price. According to this school of thought, the true value of a stock is determined by fundamental financial data and usually relies on minimal or zero speculation regarding future performance.
In the long-term, value investors expect the market price to tend toward intrinsic value, though market forces can drive prices temporarily above or below that level. Warren Buffet is perhaps the most famous contemporary value investor; he has implemented the Graham-Dodd theories successfully for decades.
Intrinsic value is calculated using financial data and may incorporate some assumptions about future returns. Discounted cash flow (DCF) is one of the most popular intrinsic valuation methods. DCF assumes a business is worth the cash it can produce, and that future cash must be discounted to present value to reflect the cost of capital. Though advanced analysis requires a more nuanced approach, balance sheet items at any given point in the life of a going concern merely represent the structure of the cash-producing business, so the entire value of the company can be determined by the discounted value of expected future cash flows.
Residual income valuation is another popular method for calculating intrinsic value. Over the long term, the intrinsic value calculation is identical to discounted cash flow, but the theoretical conceptualization is somewhat different. The residual earnings method assumes a business is worth its current net equity plus the sum of future earnings in excess of the required return on equity.
The required return on equity is dependent on a number of factors and can vary from investor to investor, though economists have been able to calculate the implied required rate of return based on market prices and debt security yields.
Some investors forgo analyzing the specifics of a stock’s underlying business, opting instead to determine value by analyzing the behaviors of market participants. This method is called technical analysis, and many technical investors assume market pricing already reflects all available information regarding a stock’s fundamentals. Technical analysts forecast future stock price movements by forecasting the future decisions of buyers and sellers.
By observing price charts and trading volume, technical analysts can roughly determine the number of market participants willing to buy or sell a stock at various price levels. Without major changes to fundamentals, the entry or exit price targets for participants should be relatively constant, so technical analysts can spot situations in which supply and demand imbalances at the current price exist. If the number of sellers at a given price is lower than the number of buyers, then it should drive prices upward.
Deciding when to sell a stock can be one of the most challenging aspects of investing. While it’s essential to know when to buy, knowing when to sell is equally crucial to maximizing your returns and managing risk. Here are five key indicators that can help you determine when it might be time to sell a stock.
1. Your Investment Goals Have Changed
One of the most straightforward reasons to sell a stock is a change in your investment goals. Perhaps your financial situation has evolved, or you’re nearing a significant life event, such as retirement, buying a house, or funding a child's education.
What to consider: If your initial reasons for purchasing the stock no longer align with your current goals, it may be time to exit the investment. Reassess your financial objectives and adjust your portfolio accordingly.
2. The company's fundamentals have declined
Monitoring a company’s financial health is critical. If you notice signs of declining fundamentals—such as decreasing revenue, shrinking profit margins, or rising debt—it may indicate trouble ahead.
Indicators to watch:
Quarterly earnings reports
Changes in management
Increased competition affecting market share
If the company’s fundamentals begin to decline, it might be a signal to sell before the stock price drops further.
3. The Stock Has Reached Your Target Price
If you initially purchased a stock with a target price in mind, reaching that price could be a valid reason to sell. Many investors set price targets based on their analysis of the stock's potential.
What to do: Regularly review your price targets and adjust them based on new information or changes in market conditions. If the stock hits your target, it might be wise to sell and lock in profits.
4. Market Conditions Have Changed
Market conditions can significantly impact your investments. Economic downturns, changes in interest rates, or shifts in industry dynamics can all affect stock prices.
When to act: Stay informed about broader market trends and economic indicators. If you sense a prolonged downturn or volatility in the market, consider reassessing your portfolio. It might be prudent to sell stocks that could be adversely affected by changing market conditions.
5. Emotional Decision-Making
Emotions can heavily influence investment decisions. Fear, greed, and anxiety often lead to impulsive choices that can harm your portfolio. If you find yourself frequently checking stock prices or feeling anxious about market fluctuations, it might cloud your judgment.
How to counteract: Set a disciplined plan before making any investment. Establish clear criteria for selling and stick to them. If you find yourself wanting to sell out of fear or excitement, take a step back and evaluate the situation objectively.
Conclusion
Knowing when to sell a stock is as important as knowing when to buy. By paying attention to these five indicators—changes in your investment goals, deterioration in a company’s fundamentals, reaching your target price, changes in market conditions, and emotional decision-making—you can make more smart decisions about when to exit an investment.
Always conduct thorough research and consider consulting a financial advisor to align your decisions with your long-term financial objectives. By being proactive and mindful, you can maximize your investment returns and reduce unnecessary risks.
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