Investment Ideas for a Tough Market; Part II

As I said in our last column, investing is not complex, but there are some basic things you should be aware of.

It doesn’t matter if you are investing in the stock market, real estate, or antique cars. The best way to protect your wealth is not to put all your eggs into one basket. This is obvious.

One of the keys to successful investing is longevity. The longer you are in the business of investing in the stock market, the more experience you gain and the more opportunities cross your path.

When you are buying a stock, you are investing in a business. The people that run that business are entrepreneurs, looking to generate a return on the capital their company invests. The people who provide this capital are investors — people like you. You invest your capital because you are looking to generate a decent return on your investment.

Naturally, if you are going to invest your money in a business, you want to have some say in how it is run, in order to protect your investment. In the stock market, however, you don’t have that luxury.

You can vote for company management or some specific initiatives, but you can’t actually participate in the company’s daily decision-making. So, this means that you do not have control over a company’s ability to allocate your capital. Therefore, the only option available to you as an individual investor in the stock market is to spread your investment capital around. You need to divide your own investment risk among a number of companies, because you can’t control the actions of any one of these entrepreneurs.

The phrase used to describe this spreading of investment risk is portfolio management. Portfolio management is a process that encompasses the creation, monitoring, and adjustment of your investments. The process never stops because you are continually buying and selling new stocks. Taking a “portfolio approach” to your stock market investments helps you stay in the game longer and improve your returns.

Taking a portfolio approach to your stock market holdings means diversifying the industries in which you invest. Not only do you need to spread your investment capital around a number of different stocks, but you also need to diversify your holdings across different industries. Owning a basket of stocks in one market sector increases your investment risk substantially, so you have to spread your money around different sectors if you want to protect your wealth over the long term.

The equity market’s sole purpose is to be a platform for the coming together of entrepreneurs and investment capital. All participants in the equity markets are taking a risk. Entrepreneurs risk their own time and capital to build a business. Investment dealers risk their own time and capital to back entrepreneurs, advise investors, and provide liquidity to the marketplace. Investors risk their own time and capital in order to see a business flourish and create wealth for themselves. The one common attribute of all the market’s players is that they are all taking a risk, with the goal of generating some expected returns.

As a businessperson managing your own portfolio, however, you aren’t running a typical business. You really don’t create a product, hire a sales force, and manage your inventory in the hopes of making a profit. As a businessperson running your own portfolio, you are engaged in the business of speculating on other peoples’ abilities to do these tasks on your behalf.

No matter how promising a stock market opportunity is, if you take the view that managing risk in your portfolio is the number one goal, you will do well in the long run.

Even the most sophisticated and experienced investors lose — big-time — in the stock market. Not only can losing be considered an element of the stock-picking process, but it also really represents the cost of doing business. No one can predict the future and no one can predict future stock prices. Risk should be your number one concern in the stock market.

Selling a losing stock position can be a very difficult thing to do. But, if one of your holdings drops 30% in value, remember that the ongoing risk to your overall financial position remains the same. Even the investment risk inherent in that same losing position remains the same — it could very well go down even further! This is why the management of risk is more important than potential returns. You cannot manage expected returns, but you can manage the amount of risk in your portfolio.

I will look at Part III of our investing ideas in the next issue.