Know what you can afford to lose and make a plan from there.
There are different types of investment risk.
Some of the greatest market price swings in recent memory happened in 2020. The volatility may scare off new investors, especially if they lost money during the spring sell-off. Thomas Martin, senior portfolio manager at Globalt Investments, says there’s more to investing risk than volatility. “The risk that (investors) ought to think about is not reaching the goal they have for investing their money in the first place,” Martin says, adding that the money used to invest should be earmarked for the long term. “It shouldn’t be the money you’re saving for necessities.” Here are seven risk-management tips for new investors.
Know what you can afford to lose.
Before people start investing, the first decision they need to make is to know how much they can comfortably afford to lose, says Kathy Carey, director of research for Baird’s Private Wealth Management group. “Then you’re going to be able to better mentally weather volatile days,” she says. This is sometimes called risk tolerance, and everyone has a different type of risk tolerance. If you don’t know yours, a financial advisor can help investors figure out their risk tolerance. Otherwise, for do-it-yourself investors, there are online surveys that can help people understand what types of price swings they can stomach.
Make a plan.
Justin Rees, senior wealth advisor with Aksala Wealth Advisors, says investors need to create a goal and a written plan for their money. The goal and the type of risk they need to take to achieve the goal should align. Rees says investors should review historical returns to understand what type of returns are really achievable. “Looking back at history is really important for new investors,” Rees says. That helps investors avoid recency bias, which is the belief that current market conditions will persist. “A review of past market action shows market drops and corrections,” he says. “Bear markets are a frequent and regular occurrence,” Rees adds. “And looking at some of those previous situations can help to turn what I would call surprises into expectations.”
Have your bases covered.
Stock day trading became popular this year when people had more time on their hands because they were working from home. It’s fine to experiment, but before dedicating money to day trading, investors need to have their other financial bases covered. Corey Walther, president of Allianz Life Financial Services, says investors need to have some basics covered – such as at least taking full advantage of an employer match in their 401(k) and having an emergency fund with three to six months of expenses in a liquid account to cover an emergency or job loss. For breadwinners, that may also include having proper insurance to care for family members. In a volatile year such as 2020, investors should consider reassessing their tolerance for risk as it may have changed, he says.
Know the different types of risk.
Sharon Duncan, president of Selah Financial Services, says risk shouldn’t be viewed as “good or evil.” Part of understanding risk and what it means is to know when to take it and when to play it safe. She says risk can be divided into three parts: emotional, behavioral and mathematical. The emotional part is how investors feel when prices rise or fall, which gives them insight to how much risk they want to take. Behavioral risk is how much risk investors may have taken in the past and how they reacted when prices fell. Mathematical risk is how much investors need to take to achieve their goals. A lot of times those three will agree – but if they don’t, Duncan says investors can’t let their emotions overrule the mathematical risk needs, which is why a plan is critical.
Don’t time the market.
Market timing is very difficult to do successfully; even professional investors don’t always get it right. Carey says for investors with a longer time horizon, consistency is key to building wealth. “If you’re coming in and out of the market, you have some serious risk of missing the best performance days. Yeah, you’re going to miss some of the bad days, but you’re most likely going to miss some of the best days, too,” she says. Even adding small amounts to long-term goals on a regular basis, no matter the market conditions, is best. For this risk-management tip, consider this market adage: It’s time in the market rather than timing the market.
Diversify your portfolio.
It’s one thing for investors to make a small bet on a hot stock such as Tesla (ticker: TSLA), but it’s another thing for them to put all of their money in one investment. “If you’re a newer investor and you don’t have a lot of money to put into the market, and you don’t have a lot of money that you can lose, you want to have broader diversification there,” Carey says. She recommends new investors start by owning an exchange-traded fund – such as one that tracks the S&P 500 like the SPDR S&P 500 ETF Trust (SPY) – before dabbling in individual stocks.
Don’t forget taxes.
Rees says as investors think about their goals and why they are saving, they need to find the right type of accounts in which to put their money. Retirement savings can be put into tax-sheltered accounts such as 401(k)s and traditional individual retirement accounts that allow investors to reduce their current taxable income. Roth IRAs use after-tax money, but the earnings grow tax-free. Educational plans such as 529s also have tax benefits. “There’s several different types of accounts that are built specifically for the goals you’re saving for,” he says. For people who started to day trade in standard brokerage accounts, they will need to pay taxes on short-term capital gains at tax time, which may come as a surprise. “People see commission-free trades without realizing that commissions aren’t the only cost associated with investing,” he says.
Remember these seven tips to manage risk:
- Know what you can afford to lose.
- Make a plan.
- Have your bases covered.
- Know the different types of risk.
- Don’t time the market.
- Diversify your portfolio.
- Don’t forget taxes.