4 ways to lower your risk & make more $$$ in the stock market
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Before we get into the meat and potatoes of decreasing your risk, we need to address emergency funds and debt.
Emergency Fund: a financial safety net for unexpected future expenses. We don’t know what will happen in the future, so make sure you have some money laying around that could cover (or partially cover) an emergency. I like to keep about 6 months’ worth of expenses in my fund at all times. It’s important to establish this BEFORE you start investing. Too many people are in the stock market with no safety net to catch them if they fall.
Debt: Most people know what debt is - something (typically money) that is owed or due - but not many people know the difference between bad debt and good debt. Bad debt takes money out of your pocket, think credit cards. Good debt puts money in your pocket, think loans to buy assets that generate cash flow. You want to stay away from bad debt as much as possible (i.e trading on margin/leverage). When you have bad debt, your risk exposure rises significantly.
Now, once you have an emergency fund set up and you’re making an effort to stay away from bad debt, it’s time to learn how to decrease your investment risk, something most investors don’t focus on.
Dollar Cost Averaging
Dollar-cost averaging, a boring (but extremely important) term most new investors disregard.
Dollar-cost averaging, better known as DCAing, is a strategy whereby you invest the same amount of money every month, or quarter, or week, or day, rather than investing a large lump sum all at once.
For example, let’s say tomorrow you get a $25,000 inheritance. You could invest it all immediately in an index fund, but then you run the risk of dumping all of your money in at a point that may not be favorable. The fund could lose 30% of its value tomorrow. Nobody knows.
If you were to DCA that money instead and invest it periodically, let’s say $1,000/week for 25 weeks, then you reduce the risk of investing with terrible timing. Instead, you capture the share price at different points, while it’s up and while it’s down. You end up buying more shares when the price is lower and fewer shares when the price is higher, averaging out your cost.
One of the main perks of DCAing is that it can be done in the background without you having to do any work. Many investment brokers offer automated buys, so you can set it and forget it. Wealth building on autopilot.
You also don’t need to worry about timing the market, something even investment professionals can’t do accurately.
Index Funds
Let’s face it, index funds are one of the best ways to invest in the stock market.
But be cautious, many index funds are also actively managed, meaning they will charge you a higher percentage to buy/sell and rebalance the fund. These fees eat into your profits and if you’re not careful you could end up with far less money when it’s all set and done.
A recent study showed that 79% of actively managed funds underperformed the S&P 500 last year. That’s insane!
Passively managed funds are a better bet. Fewer fees and a historically better likelihood of performance. Which leaves you with more money to compound over time.
Win/Win!
Market Caps
Market caps refer to the total value of all publicly traded shares. For example, if a company has 100,000 shares outstanding their share price is $10, then their market cap is $1,000,000.
Large-cap companies tend to be larger corporations, with more employees, more product lines and more revenue. They usually have more stable stock prices, but with slower growth and less risk of the stock collapsing to zero.
The reverse can be said for small-cap companies. They have more room to grow and can rise in value very quickly, but can fall just as fast.
Putting all your eggs in one type of market cap isn’t a smart idea. It’s wise to own a mixture of small, medium and large-cap companies because they offer different characteristics to investors. Spreading out your holdings by market cap is a good way to ensure you’re getting exposure to slow consistent growth but also capturing the upside potential of small caps.
Emotional Damage
Emotions are a wealth killer. The best investors are the ones who can take their emotions out of the equation. Usually the best way to do this is to have a long-term mindset. When you’re thinking in decades vs months, you’re able to see the “light at the end of the tunnel”.
Short-term price fluctuations don’t affect you because you know in the long term the stock market has historically risen in price. The worst thing you can do is buy when you’re greedy and sell when you’re scared.
There’s a saying that goes “in bear markets, stocks return to their rightful owners”.
Don’t let your emotions make financial decisions for you. If you feel like you may let your emotions get in the way, sleep on it for a couple of days and reassess the situation.
