On a practical level, investors should be more concerned with identifying the very real risks they face when they buy stocks. Fundamental analysis helps you to identify and compare risks so that you may avoid the
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As reassuring as the idea is of an “efficient” market, anyone who has invested—especially those who have lost money on a “sure thing”—
know that the short-term market is really quite chaotic and unpre- dictable.
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common problem of investing, unintentionally, in stocks beyond your risk tolerance level.
The relationship between risk and opportu- nity is direct and unavoidable. It is impossible to achieve maximum reward without also increasing risk, a point too often overlooked by investors.
Fundamental analysis focuses on a company’s oper- ating results and capital strength in an attempt to quantify risk in fiscal terms; however, it is easy to overlook this because of the ever-present stock price. So a mistaken pattern many investors follow involves these steps:
1. An initial series of basic fundamental tests are performed (a check of sales and profits, dividend rate, and working capital ratios, for example).
2. A short list of viable stocks meeting an investor’s criteria is estab- lished.
3. Ultimately, a selection is made based on recent stock price move- ments, cost levels, or high–low positioning of the stock.
This three-step process begins on a fundamental premise, but then reverts to a technical decision point. This is an appropriate system as long as you are aware of how you make decisions. The problem arises when, after developing a fundamentally based selection process, the ac- tual decision is made on technical information, specifically price. The fact that stocks have dollar values distorts this process and may result in your creating a portfolio with a risk profile higher than you intended.
There is a tendency among investors to think of $20 stocks as “more af- fordable” than $40 stocks, for example. In reality, those price levels are meaningless.
One company may have 30 million shares outstanding, valued at
$20 each, for total capitalization of $600 million. Another may have 15 million shares outstanding, valued at $40 each; this corporation also has
$600 million in capital. So the stock price means nothing. If capitaliza- tion is the key decision point in stock selection, the stock price is mis- leading, and instead of considering it, you would have more accurate information reviewing total capital instead.
risk tolerance the level of risk appropriate to each individual investor, based on income, assets, knowledge, and experience; the amount of market risk and other forms of risk a person is able and willing to tolerate.
The problem of pricing and price distortion is often seen on televi- sion financial news as well, where the sound bite is important but in- depth and accurate information is easily lost in the process. For example, if a nightly news report tells you that two local stocks both rose in value, how do you hear the information? Here is an example:
Stock A closed at $66, up 4 points Stock B closed at $22, up 2 points
Which of these stocks did better? If you look only at the point level, you would conclude that Stock A rose twice as much as Stock B. But this is an error. These daily changes can be looked at in two different ways.
Stock A’s price rose 6 percent, and Stock B’s price rose 9 percent; in other words, Stock B performed far better than Stock A. Another way to look at this is on the basis of a similar investment level. If you had $6,600 to invest, you could buy 100 shares of Stock A, and you would have earned
$400 in this market. Or you could buy 300 shares of Stock B for the same money, and you would have profited by $600 (300 shares multi- plied by a 2-point rise).
The distortion in apparent valuation arises from the way financial news is reported. It may further distort your perception of risks. For ex- ample, some investors conclude that higher-priced stocks contain greater risk, if only because it takes more capital to buy 100 shares. In fact, though, if fundamental attributes are identical, there is no difference in risk between buying 100 shares of a $66 dollar stock, and buying 300 shares of a $22 stock. Those with less capital will find lower-priced stocks more convenient to purchase in 100-share lots. But that distinction is a feature of individual capital and affordability, and not a feature of risk.
Once you accept the premise that risk and opportunity are two as- pects of the same market phenomenon, you can analyze risk in a realistic way. However, there are many different types of risk and each should be evaluated as part of the overall investment decision. These include four
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People often perceive “risk” as being related to a stock’s price or price range. In fact, the price of a stock by itself reveals nothing. You need to investigate further.
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primary areas of interest to stock market investors.
The first, market risk, is the best known. It relates to the basic idea that your investments may lose value. Stocks rise and fall, and if they fall after you buy them, you stand to lose money. In addition to careful selection of stocks, you can minimize market risk by placing orders with your brokerage firm to automatically generate sales when specific events occur, such as a loss of a specified percentage of value.
The second is liquidity risk, which refers to how available your investment funds are to you.
When you buy a house, it would require consider- able time and expense to sell and remove your equity, or to refinance. So real estate is illiquid.
When you invest in stocks, you can sell immedi- ately for relatively small costs, and your money can be in your hands within a few days. So stocks are highly liquid.
A second definition of liquidity refers to the overall market itself. The availability of sellers to match buyers (and vice versa) is also called liquid- ity. In the stock market, the on-going auction of shares matches buyers and sellers continuously and the market is set up so that even when sellers are not readily available, a specialist will complete a transaction to maintain an orderly market.
A third risk is lost opportunity risk, the risk that every investor faces whenever limited capital is committed to a particular investment. This risk arises in numerous situations. For example, if your portfolio consists of stocks that have lost value or are remaining in a narrow trading range when the market as a whole is rising, having capital commit- ted to those stock presents a lost opportunity. An- other situation involves tying up stock to cover a short option position. If that option is exercised, the covered call writer has lost the opportunity to gain profits in the stock.
market risk the risk that an investment’s mar- ket value will fall or that stocks are purchased at the wrong time, so that a temporary downward price movement results in a paper loss that may take time to recover.
liquidity risk (investment funds) the risk that funds may not be readily available in partic- ular markets, which have high liquidity risk, versus other mar- kets in which funds can be con- verted to cash very quickly, which contain low liquid- ity risk; (markets) the risk that buy- ers and sellers may not be easily matched. For example, in a slow real estate market, there will be more sellers than buyers so properties may not sell for the currently asked price; in the stock market, specialists ensure an orderly market by com- pleting orders even when buyers and sellers are not matched.
The fourth type of risk is diversification risk, the exposure created when too much capital is placed in a single stock or series of stocks. Effective diversification requires more than spreading money around in different stocks. If all of the stocks are similar in nature, subject to the same cyclical or eco- nomic forces, or likely to rise and fall in the same patterns, the portfolio is not effectively diversified.
The risk is mitigated when capital is allocated among different market sectors such as energy, phar- maceuticals, and retail; different types of invest- ments such as stocks, real estate, and savings); and different venues such as stocks and mutual funds as a collective stock market segment of your portfolio rather than different stocks.