Is investing risky?
How much risk is there to investing? Is the stock market risky? How much money can you lose in the stock market and how can you protect yourself? We answer all these questions in this mini-guide.
Risk. This is one of the main reasons some people never invest in stocks. People view investing in stocks as a sort of gambling. Hearing other people’s horror stories about losing all of their investments does not help either.
Here is the good news: Investing done right isn’t risky. All you need is to invest on the right investment product (index funds), with the proper investment horizon (a few decades), and the right mindset (stay invested).
Investing isn’t difficult, and it does not have to carry a lot of risk.
Is the stock market risky?
This depends on your definition of risk.
Can I guarantee that your investment will never drop in value? Absolutely not. Stock prices are set by humans, and humans can be irrational. Humans have their moods and, by consequence, the market has its moods too. Sometimes the market will sell you shares in a company at 10$, only to increase the price to 12$ the next day. Is this 20% increase justified? Probably not.
This is where most people get it wrong: They think because the stock market goes up and down, it is inherently risky. People make the crucial mistake of confusing volatility with risk.
Yes the stock market is volatile but only in the short term. Let’s illustrate this with the S&P 500.
Source: Google.com
This is a snapshot of the S&P 500, the benchmark of the US stock market, 5 days before the 2020 election.
As you may notice, the volatility is rampant. The market goes down, sideways, up, down again, picks ups, declines, and finally rises again. All that in just 5 days. This is irrational. There is no pattern and the chart does not tell us anything.
This is what leads people to think that investing in the stock market has risk.
This short term thinking is flawed. Buying in and out of stocks in such a short time makes you a trader, not an investor. Behind each stock there is a real company with real employees servicing real customers who pay with real cash. Think of it this way: If you and your friends set up a restaurant, would you sell your shares in the restaurant after just 5 days?
Most companies are profitable, and these profits are reinvested in the business, which allow it to grow and gain value in the process. This is why the market has always gone up over the long term.
Historical returns
Can I guarantee you that you won’t lose money in the stock market? Absolutely not, the future is uncertain, but what about the past? Let’s illustrate this again with the U.S stock market.
Source: Google.com
Look at that growth!
People will insist the stock market has a lot of the risk but look at the chart above and tell me, where is the drop? I don’t see any, I only see speedbumps. In fact, the market keeps reaching all-time highs every few years.
Investing is a winner’s game if you’re willing to stay invested over the long term.
So why do people lose money in the stock market?
If the stock market has always gone up over the long term, why have so many people lost their life savings investing in stocks? We go over the main reason below.
Reason #1 - They don't understand the stock market
People think that buying stocks is akin to gambling. This could not be further from the truth. Behind each stock is a real company with real employees servicing real customers who pay with real cash. And guess what? Most companies make profit.
Where do companies’ profits end up? In the shareholders’ pockets, and if you own stocks, this means you too! Most companies are profitable, and holding their stock means that the shareholder (you) will keep earning money every year.
Despite the yearly profits, a company’s share price may fluctuate greatly during the year. This could be because of investor pessimism about a global pandemic, a looming trade war, or geopolitical tensions (e.g. Brexit).
Reason #2 - They trade the chart, not the company
Stock prices will move up and down, this is part of the game. But don’t follow the herd.
When the market is in a euphoria over the latest trade deal or an imminent tax cut, people buy stocks in bulk, and this drives prices up. Sometimes, stock prices can be temporarily too high. When this happens some think that, because the stock price went up recently, it will keep rising. Here they traded the chart, not the company.
When the public is pessimist, or when there’s bad news, people tend to sell their stocks quickly in the hope that they will be able to sell their shares fast enough that the bad news doesn’t reach them. If enough people think this way ,a company’s stock price can be temporarily too low. When this happens some may jump to the conclusion that, because the stock price went down over the last few weeks, it will keep declining.
Once again these people traded the chart, not the company.
Following the herd and buying a stock simply because its share price is increasing is a losing technique. Even if you bought a great company, you may have paid too high a price for it.
Reason #3 - They didn't do their research
This one is crazy to me. People will spend days looking for the best deal for a 1000$ computer or holiday, but will only spend a few minutes before investing 1000$.
People read up about investing for a few hours, and immediately start buying stocks. This is a huge mistake. Imagine if people would apply the same strategy to other fields: They read up on medicine for a few hours and decide to conduct open heart surgery the next day. They fail, and start claiming that the medical sector is too risky. It takes about 13 years to become a surgeon, so don’t expect to be a successful investor in just a day.
Stocks are not just charts, they are real businesses. To understand a company, you must have basic understanding of business, finance, and the overall economy.
Reason #4 - They invest in individual companies
While the stock market as a whole has always gone up over the long term, individual companies rise and fall.
In the worst case scenario you will buy into a company which is failing, and you may lose up to 100% of your initial investment if your the business goes bankrupt.
Best case scenario? You bought into the next big thing at the perfect time and you now enjoy huge performance, but guess what? This won’t last forever.
Here’s the catch: even today’s beloved tech giants such as Amazon or Microsoft won’t maintain top performance forever. One day these companies will run out of steam, and while they will continue to be profitable for decades after this point, the double-digit growth investors grew accustomed to simply won’t be there.
Once the growth abandons the stocks, the company’s extravagant valuation will plummet too. This is where you’ll lose most of your money.
You can avoid this by diversifying your portfolio with dozens of stocks spread across different sector, but this will require an active management of your portfolio and will incur significant trading fees over the long term. This is why most investors average an annual performance of 4 to 5% instead of the market’s 8-9%.
Reason #5 - they invested too much money
This happens far too frequently. People accumulate savings, invest it all at once, and then sell their stocks when they need the money. The problem? There’s a chance that your money did not have a chance to grow yet, or worse yet, the stock market may have dropped as people turned pessimistic about the economy.
We all need cash to pay for living expenses, so it is unwise to invest everything into stocks. To be a successful investor you need to invest for the long term, and that means not cashing out for at least 10 years.
It’s simple to get around that, only invest the cash that you don’t need in the short term. Create an emergency fund where you set aside at least 2-3 months of living expenses. This way, if you’re faced with sudden expenses, you won’t be forced to sell stocks.
Reason #6 - They let their emotions get the best of them
The research has been done, do you know who are the most successful investors? It isn’t the university professors, the rocket scientists, or the brain surgeons, it’s those who can keep their emotions in line.
Investing is easy, you simply buy into an index fund and you’re done. The hard part to investing is not selling.
You will make a lot of money in the stock market, but only over the long term. In the next 10 to 30 years you can expect several stock market crashes and your portfolio will take a few beatings. You can expect your portfolio to decline by 30-50% at least once in your investment lifetime, the question is, how will you react?
Will you panic and sell stocks at a discount because “the pandemic will wreck the economy”? Or will you have the courage to invest even more money in the market and buy stocks at a steep discount?
Unfortunately humans have evolved to follow the herd, and it can be difficult to resist the urge to act when all seems desperate. Furthermore, we are predisposed to focus on bad news over good news. Think of it this way: when you found 10 euros on the street, you probably felt happy for 5 to 10 minutes, but if you lost 10 euros, you’ll probably think about it for the rest of the day.
Bottom line: humans tend to focus predominantly on the negative, this is why our news journal are full of bad news, we crave this stuff. Unfortunately this is detrimental to our investment behavior and leads many of us to sell at a large discount.
The next time you’re thinking about selling stocks, ponder on the following: If you owned a restaurant in the Caribbean and they just announced a hurricane, will you start panic-selling and sell your restaurant for half its value? Or will you honker down and wait for the storm to pass?
How to minimize risk in the stock market?
So far we’ve learned that the market is volatile, that volatility is not risk, and why people lose money in the stock market, but how do you mitigate stock market risk?
# 1 - Diversify with index funds
Individual companies rise and fall, but historically the stock market has always gone up over the term. Choosing to invest in index funds is choosing to invest in hundreds of stocks at once. Spreading your money across hundreds of companies means that you will never lose all your money (unless every single company goes bankrupt, but then we have bigger problems).
Index funds are a safe choice, they have always gone up over the long term, and they’re low maintenance.
Most importantly, the added diversification ensures that you will never be wiped out.
# 2 -Forget about volatility
The market has its moods, sometimes it goes up, sometime down, and sometimes its stubborn and it remains depressed for years, but that does not mean it’s a bad investment over the long term.
The best thing to do is to forget about market volatility, and practice DCA. Dollar-Cost Averaging is the practice of buying into the market (or a stock) progressively every month. Yes, this means that you will be buying stocks during good years and bad years, but over the long term, it will even out.
Dollar Cost Averaging ensures that you will never get screwed by temporary market bubbles. If the market rises this month but falls the next, you would have bought stocks at all times of the cycle and the only performance that would matter is over the long term, and that has always gone up!
#3 Think long term
Yes, the market may go down tomorrow, next month, or next year, but if you bought into a low-cost index funds that tracks the broad stock market, you can take comfort in the knowledge that they have averaged an annual performance of 9% over the long term.
Will the growth continues? Well we can’t know for sure but I’ll tell you this: we don’t have any indication that suggests otherwise!
The risk of not investing
We all have a friend who is dead-set against investing in the stock market. They’ll make grand claims about how the market is too high or its too risky. But what do they risk by not investing?
Inflation protection
Stocks offer great protection against inflation. The value of companies’ goods and services will likely match those of inflation, and therefore business earnings should keep up with inflation. This isn’t something you can get from a savings account.
Even bonds, which are often mistakenly viewed as safe, offer terrible protection against inflation. Historically government bonds have barely kept up with inflation and with today’s low interest rate environment, bonds’ returns are at historical lows.
Gold isn’t any better. Contrary to popular belief, gold is a horrible investment. Gold is a non-performing asset; it does not pay you yearly interest or dividend. Yes, the value of gold has increased over time, but this is largely due to inflation. Adjusted for inflation, gold has returned a real return of 1-2% per year, which is next to nothing.
Financial flexibility
One of their key advantage of stocks is that they can be held anywhere and they don’t care about your age.
Do you want to retire early? Contrary to government pension plans, they won’t ask for your age and you can simply retire once you have enough.
Do you want to live abroad? You can manage your stock portfolio online. You can’t do that with real estate. Renting your property is no easy feat, unless you’re willing to pay a heavy fee to a real estate agency.
Financial security
It’s no secret that the stock market performs well over the long term, so why not take advantage of it?
You can’t live off savings. By the time you accumulated enough cash, inflation would have eaten up a large chunk. So what’s the alternative? Slaving away at a boring job until the retirement age of 67?
You can’t rely on government pension to retire comfortably. What if your government decides to push the retirement age back a few years as they’ve done in the past? What about the mountain of debt our governments are accumulating?
The only viable way to retire early and comfortably is to invest in the stock market or real estate.
But real estate isn’t as safe as you think. Take the example of Greece, which has increased its property tax in recent years to curb its deficit, or the example of Spain, where climate change may turn southern Spain into a desert. Owning property in any of these countries 20 years ago was considered a luxury, today it’s a burden. This doesn’t happen in stocks, you can hold stocks all around the world, and your money is not tied down in one location.
Lastly, stocks provide great protection from government interference.
Are you worried that your government will heavily tax your house or your assets to pay back its debt? Are you worried about political instability in your country? Don’t be, you can open a brokerage account abroad and transfer some stocks there.
Conclusion
Investing is a must, but it does not have to be risky.
Yes, you can lose all your money if you invest in an individual stock, but that’s why you should opt for index funds.
Yes, the market goes up and down, but that’s only in the short term. Over the long term there’s a high probability that the stock market will keep rising.
Bottom line: Accept that volatility is part of the game and ignore it. Buy into low cost index funds, practice Dollar Cost Averaging, don’t let your emotions get the best of you and there’s a good chance the stock market will make you financial independent!
Want to read more? Check out our mini guides on why you should invest and how to start investing, step by step.
FAQ
High risk – stocks which are growing rapidly are in high demand, after all, who wouldn’t want to buy a stock which will double your money in less than 2 years? As a result of the stock’s popularity, investors are piling in to buy the stock and that is pushing the stock price up. This is why growth stocks tend to have high Price to Earnings (P/E) multiple.
In most cases, the company’s performance justifies its expensive share price but there’s a catch: High growth companies don’t maintain their growth forever. Eventually, the business will run out of steam and its PE ratio will plummet accordingly. The company might still be profitable, and could still be a great buy, but if you bought the stock at a high price (i.e. with future growth already priced in) and the anticipated growth does not materialise, you risk losing up 50-75% of your investment (I’m looking at you Tesla investors)
Medium risk – On one side the company will likely be reasonably priced at an average 10 -13 PE ratio. If the company has a good track record, it may continue to return stable satisfactory returns over the long term, however it has its down side.
Opportunity cost – Investing in index funds will grant average annual return of 9-10% over the long term, so if you’re investing in individual companies, you should at least get that return, and chances are you won’t find it in low growth companies.
Low risk – Holding an index funds that tracks a broad market such as the MSCI world, the S&P 500, or the Eurostoxx 600 will ensure that you hold hundreds of stocks at once across multiple industries. This will help ensure that you are never wiped out by any sudden bankruptcy or stock market crash. Over the long term index funds should beat the market if they reinvest your dividends.
The only risk that you really have is counterparty risk- the risk that your index fund issuer will go bust and committed fraud. You can reduce thar risk by investing in reputable providers (e.g. Vanguard or Fidelity) and invest in index funds which are domiciled in countries with strong investor protection regulations (e.g. the EU, US, Canada, or Singapore)