Stocks and Managing Stock Market Risk

I am a huge believer in the power of stocks to juice your net worth.  In today’s economic climate its hard to accumulate any serious wealth without getting heavily involved with business.  Since starting a business can require a large amount of cash and mandate a lot of work, stocks are an attractive option for many people.

What are they?

Stocks are basically fractional ownership units in a business.  They carry nominal ownership rights and often pay dividends. Dividends are  either cash or some other form of remuneration paid out at the discretion of corporate management.

How to stocks fit into your goals?

– Stocks are great for capital appreciation:  This is especially true for younger firms which tend to reinvest their earnings, rather than older firms which tend to pay their earnings out in the form of dividends.  Some stocks increase substantially in value.  For example, companies like Exxon Mobile and Apple Inc., have both more than quintupled their values since the companies were founded.

– Stocks are also great for income:  Stocks can pay dividends quarterly or monthly, depending on what company you own.  Some types of stocks such as real estate investment trusts are designed to pay out most of their earnings in dividends.   Established larger companies are more likely to pay dividends than their smaller counterparts because of their established business models and larger cash flows.  Dividends are great because they are income that doesn’t require your direct labor.

– You can borrow against stocks.   You can borrow against your stock portfolio.  Of course borrowing is subject to Federal Reserve margin rules and lender policies.  That said, any money you borrow against your portfolio increases both your upside potential and your downside risk.  Borrowing also decreases your cash flow.  Basically if want to eat your cake and have it too, can you do it by borrowing against your stock portfolio.

When is it best to own stocks? 

Stocks are most attractive when inflation is moderate to low, interest rates are low and business conditions are generally favorable to growth and bigger profits.   Stocks are also most favorable to buy when stock prices are low, but when underlying business conditions are healthy.

How risky is it to own stocks?  

Stocks are hugely risky.  You can lose almost your entire investment.  For example, I bought some shares of Frontline, Ltd. a few years back.  I paid $35 a share.  The company is now trading at something like $2.25 due to oversupply in the shipping industry.  You can do the math, but I’ve lost something like 95% of the value of my initial investment (ouch!).  My experience isn’t all that uncommon.  Investors have lost huge fortunes in the stock market.  So, yes stocks can be very risky

That said, most American millionaires own stocks, so if you want to become financially independent, you’ll have to learn how to manage risk in the stock market.  There are two ways to do this:

1. Diversify:  Diversification has been covered ad infinitum in the personal finance literature, so we won’t say much here.  The main idea is: don’t put all your eggs in one basket.  Get lots of different kinds of stocks and buy assets other than stocks to balance out your portfolio.

2. Educate yourself: Some risks of stocks can be reduced or eliminated by knowing the basics of equities and equity markets.  For example if you are able to read an earnings report, you’ll know which companies are having trouble.  If you can understand a mutual fund prospectus you’ll also know how to evaluate the quality of mutual fund management.

So, the bottom line is that stocks can be a great way to achieve your financial goals, but you have to be able to manage the risks inherent in owning them.

Best,

James

James Hendrickson

James Hendrickson is an internet entrepreneur, blogging junky, hunter and personal finance geek. When he’s not lurking in coffee shops in Portland, Oregon, you’ll find him in the Pacific Northwest’s great outdoors. James has a masters degree in Sociology from the University of Maryland at College Park and a Bachelors degree on Sociology from Earlham College. He loves individual stocks, bonds and precious metals.