Sometimes in life, people need to take risks. Like the chicken who crossed the road in the old joke, you need to get to the other side. If you remain on the sidewalk, you will never be Credit: Free image courtesy of FreeDigitalPhotos.nethit by a car, but you won’t get anywhere, either. In the same way, risk is an integral part of investing. If you remove volatility, you eliminate some of the chance of realizing profits. The problem with volatility is two-fold: it can’t be predicted, and all too often it causes sizeable losses.
Just because a stock may drop, this doesn’t mean that it’s cheap. When you buy a new car at a discounted price, you’ve gotten a great deal. But the same doesn’t necessarily hold true with stocks. This is because prices often drop for a reason. The fundamentals or management of the company may have changed, or consumers may no longer be interested in the product. Sometimes stock prices are intrinsically too high and the “devaluation” is a correction. Remember Polaroid? It traded at $28 in 2000, and then at $2.80. Today it no longer trades.
When buying a stock, it is prudent to assume that at some point during your holding period, the stock will drop in value. It may fall in price immediately after you purchase it, or it may not decline in value for several months, but assume that eventually the price will go down. Therefore, to avoid panic-selling it’s wise to anticipate a drop in price and prepare your action accordingly. Then, you can hope that in the long term, the value will appreciate.
While “risk-free” sounds as if you can’t lose, by removing the potential for growth you introduce the possibility that your investment may not maintain its value. This is because inflation can decrease the real value of your money. Therefore, some degree of risk is needed if you want your investments to maintain their long-term purchasing power.
At times, it may seem like balancing on a tightrope may be easier than maintaining the right amount of risk in your portfolio. In both situations, sudden moves may spell disaster, but careful planning and keeping your wits about you may help you keep your investment portfolio - and financial future - on the right track. So if you want to be like the chicken who crossed the road, do it carefully – but don’t stay on the sidewalk.
For more information on assessing risk in your investments, read: A Question of Risk Strategy: How Do You Know What Works Best For You?
Disclaimer: This article is for educational purposes and is not a substitute for investment advice that takes into account each individual’s special position and needs. Past performance is no guarantee of future returns.