Totally Free Market Analysis
In a nutshell, there are two types of risk when investing in a stock:
#1 - Company risk - or Unsystematic risk
Company or industry specific risk that is inherent in each investment. The amount of unsystematic risk can be reduced through appropriate diversification. Also known as "specific risk", "diversifiable risk" or "residual risk". For example, news that is specific to a small number of stocks, such as a sudden strike by the employees of a company you have shares in, is considered to be unsystematic risk.
#2 - Market risk - or Systematic risk
The risk inherent to the entire market or entire market segment. Also known as "un-diversifiable risk" or "market risk." Interest rates, recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification. Whereas this type of risk affects a broad range of securities, unsystematic risk affects a very specific group of securities or an individual security. Systematic risk can be mitigated only by being hedged. Even a portfolio of well-diversified assets cannot escape all risk.
So, the easiest way to get rid of risk is through portfolio diversification. Proper diversification will essentially nullify the individual company risk of each stock that you own.
Q: Uh, I own Google, Apple, Microsoft and RIMM. Am I diversified. Google is an internet play, Apple makes tech products, Microsoft is a software play and RIMM makes cell phones.
A: You're not quite there. Diversification should be thought of as investing in different industries that have as little effect on each other as possible:
Ex. Tech, Industrial manufacturing, consumer staples, health care/pharmaceutical, energy
Q: I own three stocks, am I diversified in three different industries.
A: No. Research shows that at least 5-10 stocks should be chosen to get a diversified portfolio. Some research states that company risk doesn't really go away until you own 30-40 different securities. More on that in a second.
Q: Should I sink all of my money in at once, or should I space out my buying?
A: In my opinion, this one depends. There is something called dollar cost averaging. The novice investor should invest constantly adding a little to the pot each month. Over the long term, this constant investment provides purchases at various prices which should all appreciate at 8-12% on average. The serious, experienced investor may want to make large plays when market conditions warrant it. If that is what you plan on doing, always have some cash set aside for the next big purchase.
Q: Which mutual funds should I choose?
A: Depends. Mutual funds are great in that the diversification is built in. However, there isn't a single mutual fund I know of that invests in the world. It's just too broad. In fact, there is some research out there that suggests you can be overly diversified, especially in mutual funds and that can hurt returns as well.
You have to look at a couple of factors: Age/ Investment time Horizon (how many years to retirement), Risk tolerance, job safety, other investments, income level, etc.
If you're young 20-30s, you should have a more aggressive portfolio and invest in riskier things.
In you're 40s, you should start to move into safer plays, like some bonds, but a healthy dose of equity stocks
50s - after you buy your viagra, you should continue to shift more into safer investments with a good spread of mutual funds, dividend returning stocks and bonds.
60s - most of your investments should be safeguarded in fixed income/bonds with a little exposure to equity still.
All this assumes retirement at age 65.
Small cap funds - invest in smaller companies with higher risk. Very volatile. Higher returns on avg with about 14.5% over the long term. Large swings up and down in values. Better for investors with longer time horizons for investment.
Mid cap funds - medium sized companies, but still fairly risky. Med to high volatility. Returns avg 12% or so
Large cap funds - your mega companies. Dividend players. Lower growth is traded for dependable returns and dividends. 8-10% return on avg.
International funds - You should see what countries are the funds concentrated in and ensure the funds isn't overly weighted in emerging nations. These were hot mutual funds the last few years with BRIC countries (Brazil, Russia, India and China) all skyrocketing. Right now, Asian markets are sucking except for Japan which has shown to be surprisingly resilient and still increasing. International index funds return 8-12% on avg over the long term.
Index funds: S&P 500 funds, Wilshire, etc. Also find long term plays. Realize that S&P is weighted towards largest companies and Wilshire is targeted towards smaller companies.
There are many more mutual funds out there which are more narrowly focused. ETFs (exchange traded funds) are also nice because they trade like stocks in which you can buy and sell them almost immediately.
So, bottom line, and without delving into Betas and Weighted average cost of capital and other formulas, you need to diversify in order to protect yourself from being overinvested too heavily in one area. My personal opinion is this:
If you don't plan to spend several hours a week following your stock investments and reading Quarterly earnings reports, Annual reports, studying ratios, and paying attention to the various news sources, than you should stay away from stocks and invest in mutual funds. If you do as I do and spend at least an hour a day reviewing information on various opportunities, then stock picking may be your ticket to improving returns.
I recommend the following books for those getting serious on investing: Rich Dad Poor Dad by Kiyosaki, Peter Lynch's Beating the Street, Jim Cramer's Real Money: Sane Investing in an Insane World, and Warren Buffets book. Each investor has a different investment strategy that you can learn from even if you don't like their investment styles.
If you're lazy, don't care to learn about your investments, pay a professional to invest your money or pick some index mutual funds and invest in 4-6 different funds including: International index funds, domestic index funds, small, mid and large cap funds and other different value, growth or blended funds. Value funds look to invest in undervalued funds, growth funds look to invest in fast growing companies, and blended funds mix in both types of strategies. For example, you can invest in Large cap growth (which is hard to find by the way) or Large cap (value), or midcap growth or blend or value funds, etc.
Totally Free Market Analysis
