The decision of whether to invest in the stock market is something many individuals will consider and reconsider over their lifetimes, particularly as they prepare for retirement. From 401(k) to IRA elections, reducing investment risks over time through a diversified portfolio can help augment retirement goals. Other investments tied to stock performance include profit sharing, the purchase of individual company stocks, stock option awards from an employer, and the purchase of individual mutual funds.
Although the rate of return or performance of an individual stock or equity investment is not guaranteed, a higher rate of return is typically associated with a higher level of risk. Defining investment goals, including risk tolerance and the expected rate of return, is a critical step to being able to manage and reduce risk exposure. For example, someone who has a longer period to invest or more than twenty years until retirement will often be more risk-tolerant than someone who only has a few years until retirement. Knowing how much risk tolerance a person has, in addition to future financial needs, is critical to mitigating overall risk whether the overall stock market is in a volatile or non-volatile period.
Diversifying stock options is one of the more popular and tested means of reducing risk. The practice of diversification is about purchasing a variety of stocks with different rates of return and risk levels, according to investment goals. When trading options from TradeZero, for example, an investor might choose a few stocks with a high rate of return, some with a mid-rate of return, and some with a lower rate of return. The thought behind diversification is that the lower risk investments will help balance out the higher risk investments over time.
Of course, a good diversification strategy also considers the investor’s timeline and the historical performance of individual stocks over a given period. Looking at individual stock performance over a one-year, five-year, ten-year, and higher is a sound way to determine whether an individual can tolerate the investment’s expected risk. However, not all stocks or mutual funds will have historical data that spans the same periods. This will depend upon how long the stock or mutual fund has been trading on the public market.
Even though historical performance data on individual investments exist,it is not a guarantee that the investments will continue to perform at those levels. Changes in market volatility, for example, can impact some stocks and mutual funds more than others. A decline in overall macroeconomic conditions, such as global or national recessions, can impair short-term and long-term performance. Sudden shifts in the overall stock market’s performance due to unforeseen global events or emergencies can also result in sharp short-term declines in value, followed by sharp short-term recoveries.
Planning for market volatility depends on when it occurs and the investor’s short-term and long-term needs. During periods of volatility, an investor may want to restructure his or her portfolio, provided the investor is able and willing to take on the risks of selling under-performing stocks and purchasing new investments that might have long-term potential. Some may also choose to shift future investments to more stable mutual funds or stock options to ward off the ups and downs during periods of volatility.
However, whether the market is volatile or steady, periodically monitoring the performance of individual investments and the portfolio’s overall performance is necessary. Take a look at whether the overall portfolio’s rate of return is acceptable each year and pinpoint the actual past year performance of each individual investment. Does it match or come close to the historical data and the investor’s goals or expectations? What are the updated projections for each investment’s short and long-term performance? Are there new investment options available that might help improve the portfolio’s overall performance and meet one’s goals?
Evaluate and Define Investment Goals
Just as an investment portfolio’s performance needs to be periodically monitored and evaluated, so does as individual’s goals and risk tolerance. Changes in age, life circumstances, and investment goals can call for different risk mitigation strategies. While some 401(k) elections offer mutual funds that help automate the management of some of these types of changes, even these types of elections need periodic assessments.
Generally speaking, the longer a person has to invest and hold various stocks, the more risk and volatility can be tolerated in exchange for higher rates of return over an extended period. Seeking a high rate of return over the long-term is one type of investment goal with a higher rate of risk that can be mitigated by investing in more than a single stock or mutual fund. However, if a person needs to suddenly leave the workforce or drastically change one’s employment situation, that previous investment goal may also change. The immediate need to preserve investment value or draw upon investments for short-term income may necessitate a reallocation of investments.
Also, an investor should periodically evaluate how much he or she can afford to contribute. Typically, a higher discretionary income may coincide with the ability to purchase more stocks and investments. Yet, this is not necessarily a sound way to mitigate or reduce risk, especially if a person does not have an emergency savings fund built up or needs to consider other existing investments such as real estate. Changes in income over time and the need to spread out contributions among various elections can impact risk tolerance and mitigation strategy.
Investing in stocks, whether on an individual basis or through an employer’s retirement plan, will always carry a degree of risk. Changes in overall market performance, macroeconomic and environmental factors, and individual stock or mutual fund performance can all impact risk levels. Yet, individual investors can help mitigate the risks involved in trading stocks by adhering to several sound principles. Diversification, defining and periodically assessing investment goals, defining and periodically assessing individual risk tolerance, examining individual investment and overall portfolio performance, and evaluating actual performance against historical or projected performance can be included as part of an investor’s mitigation strategy.