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Friday, August 19, 2016

Is stock investing risky?

To be able to answer that question, one has to understand the meaning of risk. The problem is: there is no clear cut definition of risk, or the best way to measure risk.

Volatility is often considered a measure of risk - particularly by inexperienced investors. But seasoned traders thrive on volatility and make most of their money from it.

One often thinks of a bank fixed deposit as 'safe'. Why? Because there is very little chance of losing your principal amount. 

Compared to a bank fixed deposit, stocks seem more 'risky'. Why? Because during a bear phase the price of a stock can fall below the price at which it was bought.

Many small investors fall into the trap of such a simplified view of risk and choose the 'safe' option. What they fail to realise is that safety also comes at a price.

Returns from fixed deposits are taxable and subject to fluctuations in interest rates. A 3 years deposit earning 8% interest may seem like a good safe return, but the real rate of return is only 2% if inflation is 6%.

There are a couple of ways that risk can be reduced when investing in stocks. The first is by diversification: (i) across market capitalisation, i.e. investing in a mix of large-cap, mid-cap and small-cap stocks; and (ii) across sectors, i.e. buying stocks from auto, pharma, FMCG, financials, etc.

The second is by portfolio diversification through investment in different asset classes, like stocks, funds, fixed income, gold.

Another way to reduce the riskiness of stock investing is by learning the basics of technical analysis. 

While fundamental analysis is a must in understanding the financial robustness and competitive advantage of a company, technical analysis provides signals of when to buy, when to sell and when to sit tight.

Plus, the concept of a 'stop-loss' allows an investor to exit with a smaller loss when a stock's price is tumbling down.

If you are not adept at picking stocks, you can still invest in stocks and diversify your portfolio by buying units of different mutual funds.

By choosing the 'dividend option' in a fund, risk is reduced because the periodic dividend payments act as partial profit booking and freeing up some cash that can be utilised elsewhere.

So, the answer to the question is: No - provided you know what you are doing.

To learn more about risk, here is an interesting article from investopedia.com.

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