Nervous about bear markets, crashes, and corrections?
Equities offer outstanding returns in the long term, but their volatility can be terrifying in the short term, especially for new investors. Fortunately, investors have plenty of options to reduce risk in their stock investing and sleep easy at night.
But for all the benefits that stocks and equity funds offer investors, they’re not appropriate for everyone all the time. Here’s what you should do before investing a penny in the stock market, and 12 strategies to reduce risk once you start investing…
Prioritizing Your Financials Properly
The S&P 500 has returned over 10% per year on average over the last 32 years, as exchange holding company, Cboe reminds us.
While that’s a healthy return, it’s also significantly lower than the average credit card interest rate — around 17% — according to CNBC. For the average consumer, that makes paying off credit card debt an indisputable priority over investing in the stock market.
Other high-interest personal debt, such as unsecured personal loans, also usually make sense to pay off before investing money in the stock market. There’s no magic interest rate above which you should prioritize paying off a debt, rather than keep it. But for my own money, I pay off any debt charging interest over 6% before investing elsewhere.
Likewise, most personal finance experts agree that everyone — regardless of age or income — should have an emergency fund. How much that emergency fund should hold is a subject for greater debate; financial experts recommend anywhere from one month’s worth of expenses up to one year or more. People with less consistent incomes, or less job security, should put more aside in their emergency fund.
How much you put aside in an emergency fund is a personal decision based on how conservative you want to be. But before investing anything in the stock market, put aside at least one month’s household expenses in a cash emergency fund.
If you need to set up an emergency fund, consider a high yield savings account from CIT Bank. They offer one of the highest APY’s available from an online savings account.
Reduce Risk in Stock Investing
Once you’ve paid off your credit card debt along with any other high-interest personal debt, and set aside an emergency fund, it’s time to start investing. And while there are countless investment options available to you, from real estate to bonds to crowdfunding websites, stocks are an easy starting place offering high average returns.
Try these 12 techniques for reducing risk without settling for low-return investments, to enjoy the many benefits that stocks offer investors.
1. Dollar-Cost Averaging
Many new stock investors’ eyes glaze over when they hear terms like “dollar-cost averaging.” However, the concept is extremely simple, so glaze not.
Dollar-cost averaging simply means investing the same amount of money every month, or quarter, or some other regular interval, rather than investing a large lump sum all at once.
Say, for example, that you inherit $50,000. You could invest it all immediately in a mutual fund, or you could gradually invest it in that mutual fund over time. By investing it periodically in drips, you reduce the risk of investing with terrible timing, just before a market correction.
On the other hand, instead of investing all $50,000 at once, you could invest $1,000 per month for the next 50 months. Or $2,000 per month for the next 25 months, or whatever division you like. The important point is that you spread the investment over time.
That way, as the price per share of the stock or fund fluctuates, you end up investing closer to the long-term average price. Because you’re investing the same amount of money, the fluctuations in price mean you’ll buy more shares when the price is lower, and fewer shares when the price is higher. To quickly illustrate, say you invest $1,000 per month in SWPPX, an index fund tracking the S&P 500. Here’s imaginary pricing to showcase how dollar-cost averaging may look in the first five months:
- Month 1 Price: $30. $1,000/$30 = 33.3 shares
- Month 2 Price: $25. $1,000/$25 = 40 shares
- Month 3 Price: $27. $1,000/$27 = 37 shares
- Month 4 Price: $31. $1,000/$31 = 32.3 shares
- Month 5 Price: $33. $1,000/$33 = 30.3 shares
After five months of dollar-cost averaging, you would have invested $5,000 and would own 172.9 shares, for an average cost per share of $29.
Pros & Cons of Dollar-Cost Averaging
Aside from the primary advantage of spreading risk over time, there are a few other pros and cons that investors should understand about dollar-cost averaging.
One advantage is that investments can — and should — be automated. Once you know what stock or fund you want to buy and how much you want to invest every month, you can set up automated recurring purchases to take place on the same day every month. It happens in the background, with no work or thought required on your part. You can even combine automated savings with automated investing using these financial automation apps.
Betterment is one of our favorites because you can auto-deposit money from your checking account to your investment account. The best part is that Betterment doesn’t charge for each trade or transfer.
Another advantage is that you don’t need to worry about trying to time the market. Professional investment advisors often fail to accurately predict market swings, which speaks to your own odds of correctly timing the market.
There is one downside worth mentioning. For financial hobbyists who follow equity markets religiously, dollar-cost averaging won’t help them beat the long-term average, as by definition it aims for that very same average cost per share. So, while dollar-cost averaging will help you avoid below-average returns, it also precludes above-average returns.
2. Index Funds
Actively managed funds are expensive.
Because these funds are actively managed by a fund manager trying to beat the average market returns, they charge higher fees to investors. These fees eat into investors’ returns.
Partially due to these higher fees, and partially due to human error, actively managed funds tend to underperform the broader market rather than beat it. In one study reported by U.S. News and World Report, 95% of actively managed mid-cap funds underperformed the mid-cap stock indexes. The numbers were little better for small- and large-cap funds (more on market capitalization shortly).
By contrast, a passively-managed index fund simply mimics a stock index, such as the S&P 500 or the Russell 2000. Plus, no labor from overpaid fund managers is required.
Thus, these index funds charge far lower expense ratios, often one-tenth or one-twelfth of the cost charged by actively managed funds. That leaves more of your money invested, to compound over time.
3. Diversification Across Market Caps
Diversification — spreading your proverbial eggs across multiple baskets rather than one — is a common approach to reducing risk. And diversifying across market caps is one of several forms of diversification.
Market capitalization refers to the total value of all publicly traded shares for a given company. To use simple numbers, if a company has 100,000 shares outstanding, and their share price is $5, then their market capitalization (market cap) is $500,000.
This is one way of referring to the size of a company, instead of by the number of employees. After all, companies with few employees can still earn millions of dollars each year and be worth a great deal of money, while companies with many employees can earn little or no profits.
But in general, large-cap companies tend to be large corporations, and small-cap companies tend to be far smaller in both profits and employees. Large-cap companies also tend to have more stable stock prices, with both slower growth and less risk of a pricing collapse.
Smaller companies have more room to grow and can rise in value quickly. But they can also fall just as quickly.
By spreading your money across small-, mid-, and large-cap index funds, you can balance both the potential growth of small-cap companies with the stability of large-cap companies. For example, the S&P 500 is an index representing 500 of the largest companies in the U.S., while the Russell 2000 represents 2000 smaller-cap U.S. companies. You can invest in index funds that mimic these indexes (such as SWPPX, mentioned above), or any other index around the world, to target a specific market cap and region.
4. Diversification Across Regions
Just as investors can spread risk across different market caps, they can also spread it across different geographic regions and countries.
U.S. and European markets, as advanced economies, tend not to grow as quickly as emerging markets. Emerging markets such as Brazil or Vietnam have room for fast growth, as their economies strive to catch up with the likes of Japan and the U.S. However, they can also collapse quickly, due to political instability or economic crises.
As with market caps, you can balance risk and growth by spreading money across funds operating in multiple regions. I personally aim for 50% U.S. funds and 50% international funds, but there is no magic rule for success. In general, the less developed the economies in the regions where you invest, the greater potential there…
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