Financial Learning Center

Managing risk is one of the most important jobs you have when you are investing. The key way to do this is to spread your risk among different investments. By putting your eggs in different baskets, you are “balancing your portfolio” and spreading your overall risk.

As you know, markets go up and down. But these ups and downs are uneven and unpredictable. When one part of the market goes up, others can go down. When stocks go ups, bonds often go down. Even on the same news, the impact can be different.

This volatility can be managed to some degree. Events like drops in commodity prices, bad management decisions, product recalls, and changes in regulations hit individual companies, industries and countries differently. These are called non-systemic risks, and these risks are what you try to manage though balance.

The tool that is used to balance non-systemic risk is diversification. By diversifying your portfolio, you can manage some of your risk. You can do this in three ways: diversifying by asset class, geography or industry.

Most of the heavy lifting of diversification happens by diversifying by asset class. When you invest, you can buy stocks, bonds and funds, or just hold cash. Each of these asset classes behaves in its own way. Stocks tend to be more volatile and risky. Bonds tend to be much less volatile and more stable. Stocks and bonds also tend to move in opposite cycles. And cash keeps its value even in market downturns.

So by spreading your portfolio among these asset classes, your portfolio can be somewhat insulated from different types of market forces. Something that hits stocks hard may be a benefit to bonds and something that hurts bonds can sometimes help stocks. So by mixing your asset holdings, your portfolio can weather many kinds of market storms.

You can also diversify your portfolio geographically. If your portfolio holds lots of US stocks, it would be a good idea to diversify by buying European or Asian investments. By spreading your money this way, a downturn in the US will only impact part of your portfolio.

Finally, you can diversify by industry. Different industries run in different cycles. A downturn in oil prices for example may be devastating to oil companies, but lower fuel prices are a boon to transportation. By buying into different industries you will make sure that a down-cycle in one part of your portfolio will not spread to your whole portfolio. If you start with broad categories such as primary industries, manufacturers and services, you can branch out into more specific categories once you get the hang of it.

Also note that Exchange Traded Funds (ETF), can be an simple, low cost way to instantly diversify your portfolio. You can find ETFs that are diversified by geography, industry or asset class. A single fund can do a ton of diversification work for you, especially when you are just starting out.

Now that you know how to balance your portfolio, we need to look at the most important part of balance: you! No matter how you balance your portfolio, you need to take into account your own risk tolerance. If you don’t have much of an appetite for risk, or really cannot afford to lose money, then your portfolio should be balanced towards more conservative products.

The most effective way to manage risk is through asset allocation, specifically the proportion of stock, bonds and cash you hold. If you have a conservative risk profile, it would be good to hold more bonds and cash and a lower proportion of stock. If you can accommodate a lot of risk, you can hold a greater proportion of stock.

As a guideline, this is a sample of what a balanced portfolio should look like: A conservative investor can have a mix of 70% bonds, 20% stocks and 10% cash. For an aggressive investor, the holdings are inverse, 70% stocks, 20% bonds and 10% cash.

If you don’t have an appetite for risk, choose a bond fund at the core of your portfolio and take only a small proportion of stock. If you have a higher tolerance for risk, maybe take a more aggressive fund as your core, and take a larger proportion of stock.

One last thing, it’s always good to go back and revisit your balance every three months. The value of your holdings will change over time, so your balance will change. Make sure you check to see if you’re comfortable with your new balance. If you’re not, rebalance by selling some of the asset where you’re overweight, putting the proceeds into the assets where you’re underweight.

So that’s balance. It’s easier than it looks. Start by diversifying between stocks, bonds, funds and cash. Use ETFs to do some easy diversification for you. Aim to diversify even further by industry or geography if you can. But make sure you’ve taken your own risk tolerance into consideration. If you do this well, even if one part of the market hits the rocks, your overall portfolio won’t be impacted severely. And that’s the goal of balance: making sure a downturn in one part of the market doesn’t ruin your whole portfolio.

This is important to know right away - shorting a stock is risky and is not appropriate for a novice investor. But (and this is a big but) it can be an appropriate for some investors in some situations. It does serve a purpose. Sometimes…

The end goal of investing is growth - increasing value, saving for the long-term and building wealth. So talking about shorting a stock seems to be something of a contradiction. And it is. When you short a stock, you are investing with the belief that the security you invested in will go DOWN in value.

So why would anyone want to do this? That’s a good question… First of all, not all investments are good investments. Some companies are victims of terrible management. Other companies are crushed by competition. So not all investments are going to go up in value.

So what do you do if you see a company that you think is running into trouble? You can ignore it and look for a better opportunity, or you can short the stock in the hope that it goes down and you make some money.

The exact mechanics of a how a short sale works are a little bit upside-down. In a short sale, you want to reverse the traditional order of your transactions. Instead of buying low and selling high, you first have to sell high then later buy low… In fact, you need to borrow shares from someone else in order to start the short selling process (you can’t sell shares you don’t own!). So your broker will get them for you either through its own clients, or through its custody banks and clearing firms.

Once you have borrowed your shares, you can then sell them, depositing the proceeds in your trading account.

So now you have a chunk of cash in your account, but you also  have a liability: You owe someone those shares that you sold. At some point you will need to buy the shares back and return them to your broker. In the meantime, your broker will require you to keep enough funds in your account to cover at least 150% of the price of your stock. You need the money to buy the stock back after all, so your broker will watch your balance to make sure you have enough cash to cover the cost of the shares, plus another 50% of its value.

So let’s look at how to close a short. As we said, you have to buy the shares back in order to return them to whomever you borrowed them from. This is called ‘short covering’. If the stock has gone down 10%, and you buy the shares back at that lower price, you just bought them 10% cheaper than the price you sold them at. That means you made a 10% profit. Awesome!

But wait… What if things go the other way? What if the stock that you’re hoping will go down actually goes up? What if your battered stock is suddenly the target of a takeover? And what if the stock you initially sold for $5 has now jumped to $12 on the takeover news? If you received $5,000 from the initial sale, the shares will now cost $12,000 to buy back. Your $5,000 will no longer cover the cost of the stock. In fact, you will have to find an additional $7,000 out of your own pocket to complete the transaction! Your broker will also be demanding that you cover this shortfall immediately (which is referred to as a ‘margin call’). Closing the short sale at this price will result in a total loss of 140%! You will have lost not only what you invested, but also extra money out of your savings as well. Ouch!

So unlike going long on a stock (i.e. buying it in the hope that it goes up), short selling has unlimited downside. You can lose not only all the money you’ve invested in the short, but more on top of that. So it can be a very dangerous investment.

Another downside risk of short selling is when a dividend occurs. If a company issues a dividend while you are short selling the stock, you owe that dividend to the person who loaned you the stock (remember, you’re just “borrowing” the stock. You can’t keep the stock or the dividend). But the company you’re shorting will not give you that dividend (you don’t own the stock after all), so you will have to pay the dividend, out of your own pocket, to the person you borrowed the stock from. This can be a substantial added cost to shorting a stock.

But (professional) investors short stocks all the time. And there are some good reasons to do that. First of all, there are times that shorting a stock makes sense. Most often it is used as a protection against a falling stock market. By shorting stocks, it protects you from the downside of a dropping stock price. So when stock prices drop, your long positions will lose money, but your shorts will go up in value, keeping you from losing too much money. It is difficult to manage these hedges, but if they work properly, they can protect you from dropping stock prices.

Hedge funds are big fans of these types of short sales. They often employ a strategy called ‘long/short equity’ where they hold a mix of long positions to profit from risings stocks and short positions to profit from dropping stocks. They can be profitable strategies, but are also complicated and expensive to manage, so are not generally employed by individual investors.

So how does this all impact you? The existence of short sales actually benefits average investors, even if they don’t short shares themselves. Short sellers help investors by adding liquidity to markets. They buy and sell shares when others are reluctant, so they keep the market working during difficult times.

Short sellers can also be a great barometer for the value of individual stocks. When short sellers pile into a stock, it generally indicates that the stock is over valued and the short sellers are preparing for the stock to drop. Called ‘short interest’, if it is rising, it indicates that the market may be turning against the stock.

Interestingly, when short interest is extremely high, it sometimes indicates that a stock is about to turn upwards. This may sound counter-intuitive, but there is logic behind this. When there are a large number of short sellers in a stock and the stock has dropped, they will at some point, want to close their positions to lock in profits. In order to do that, they’ll need to BUY the stock. When large numbers of short sellers start to buy the stock, the demand will push the price of the stock up. And as the rise accelerates, more and more short sellers will want to close their positions to lock in profits (or prevent losses). This is called a ‘short squeeze’ and is usually an indication that a stock has found a bottom to its price.

In the end, short selling should only be considered in exceptional circumstances. The downside risk of shorting is extreme, and should only be undertaken by experienced traders. But for average investors, short sellers can still help by providing liquidity to markets and give valuable information about sentiment towards specific stocks.

Buy low and sell high. That’s what every investor wants to do. If you sell a stock for more than you bought it for, you make a profit. That’s the goal in investing.

So prices are important to investors. But how important are they? When you buy or sell a stock, is it important to set a specific price to buy or sell at? Or is it ok to let the market choose the price for you? The short answer is: It depends.

Let’s start out by explaining the three different ways you can submit an order to a stock market: market orders, limit orders and stop orders.

‘Market orders’ are orders for a specific number of shares of a specific stock. But in market orders, no price is set. The investor submitting the order allows the market to dictate the price – meaning you buy or sell at whatever the price is at that moment in time.

The advantage of market orders is that your order is almost always filled. It allows you to get into or out of a stock quickly.

But the problem with market orders is that in order for your order to be filled quickly, you have to give up on a specific price. On an average day when there are lots of buyers and sellers, this generally isn’t too much of a problem.

But market orders can run into trouble when dealing with shares of small companies or when trading turns volatile (swings strongly up or down). In these situations there is often an imbalance of buyers and sellers. This means that the market may have some trouble connecting a buyer with a seller. Even though market orders look for the “best price available”, the best price is one that has to move so that the order can get filled. In these situations, you may be disappointed to find that the market’s “best price” may not meet your expectation of “best price.”

But if you’re looking to invest for the long term, giving a bit on price is not much of a sacrifice for the confidence of being able to get in and out when you want. Just be careful with small companies, and on days that the marking is fluctuating.

Another type of order is called a ‘limit order’. Like a market order, limit orders have a specific number of shares of a specific security. But unlike a market order, these orders include a specific price. When you sell shares, you want to get the highest price possible. So a limit order to sell shares sets a price BELOW which you will NOT sell your shares. If you submit a limit order to buy, you want the lowest price possible, so your order sets price ABOVE which you will NOT buy your shares.

The odds of your order filling depend entirely on how far your price is away from the current market price. If there is a big spread, it is unlikely that your order will fill. But often the market will move to your price and your order will fill.

Limit orders are often used as a way to plan your portfolio far into the future. If you like a company and want to add it to your portfolio, but the price is too high, you can set a buy order at a low limit price and wait for the market price to come down. If the price of that company’s shares slide to that price, your order will fill, giving you the bargain you were looking for.

This strategy also works when you sell stocks. If you own shares of a company and want to maximize your return, you can set a limit order to sell at a price above where the market it currently trading. If the price of those shares hit your target, your shares will sell, thus unlocking the profit you were looking for.

These limit order strategies are a great way to build discipline into your buy and sell decisions. Just make sure you keep track of your limit orders and change them if market conditions change.

Also note that in order to close your position, there has to be an investor willing to meet your price and size conditions. It sometimes happens that even if the market hits your price, your order cannot be filled because a matching buyer or seller cannot be found at the price and the number of shares you require. Limit orders are rigid and must trade at the specified price. So it sometimes happens that the market will touch the price you want, but your order will remain unfilled

The obvious weakness of limit orders is that there is no guarantee that they will fill at all. If the market cannot meet your price, your order will not go through. By sticking to a specific price, investors take the risk of missing out completely on getting in or out of a stock.

The final type of order is a ‘stop order’ (also known as a ‘stop-loss order’). It’s something of a hybrid of a market order and a limit order. It behaves like a limit order, in that it carries a set price. But it behaves like a market order in that once the market hits the target price, the order is triggered as a market order. So it allows you to have price assurance with the added benefit of almost certain completion.

Stop orders are frequently used as way to prevent excessive loss. An investor can set a stop-loss order for a security that they own, to have it triggered when a stock drops below a set level. For example, if you bought Apple at $95, you can set a stop-loss order at $90 so that you limit your maximum loss to $5 per share.

Another other version of a stop-loss order is a ‘trailing-stop order’. In this order, you can set a loss limit, but instead of tying it to your purchase price, the limit is tied to the actual trading price of the stock. So if you buy Apple at $95 and set a $5 trailing stop, the stop would initially be set at $90. But if Apple’s price moves up to $100, then training strop would move up too, and would now be set at $95. 

Trailing stops are a great way to have flexibility in your stop losses. It is also a way of managing risk in your portfolio without you having to pay constant attention to it. If you travel or are busy, stop orders and stop-losses are a great way of preventing unexpected loss in your portfolio.

The only warning about limits and stop losses is that they can sometimes be triggered inadvertently. Market fluctuations can sometimes throw stocks into sudden, quick drops. In May 2010, the New York Stock Exchange saw a sudden and unexpected 1,000 point drop, hammering many notable stocks in its wake. Within 15 minutes, the exchange had recovered to previous levels, but that drop would have triggered thousands of stop orders, wiping out billions of dollars of investor savings.

These events are very rare, but show the vulnerability of stops. They can allow you to plan into the future, but even with all of the best laid plans… things can still go wrong.

So what’s the conclusion? Should you be setting a price for your buy and sell orders?

First of all, there is nothing wrong with using market orders for most of your transactions. If you buy and hold for the long term, this strategy will work well. The impact of not getting a perfect price is not tremendous over the long term.

But, if you build a targeted plan for buying or selling stocks, then limit orders are a terrific idea. You can then get stocks when they go on sale and lock in profits when your stocks rise.  

And finally, if you can’t pay full attention to your portfolio, or you feel you need some protection against loss, then stop orders may be right for you too. Just make sure you use them carefully.

If you had a choice to invest in real estate, gold, bonds, or stocks, which investment, has historically given the best return? It’s stocks. Hands down. Through thick and thin, the US stock market has returned on average 7% per year. Even after recessions, dot-com bubbles and economic meltdowns, stocks still have the best returns over time of all asset classes.

So let’s look at stocks and see why they have traditionally been such good investments.

First, let’s start with what a stock is. Stocks, also called equities or shares, are an ownership stake in a company. When you buy a share, you actually become an owner of small percentage of a company. As an owner you get certain benefits, which vary depending on what kind of stock you own.

There are two types of stock you can buy. First, are common shares. These are by far the most widely used form of stocks. They give the shareholder an ownership stake in the company, and with it, the right to vote at shareholder meetings. An owner of common stock can also share in the company’s profits, which are distributed as dividends (if the company offers them). Common shares are traded on stock markets and have prices that fluctuate based (generally) on how well, the company is performing.

Preferred stocks are a different class of shares. They are also an ownership stake in a company, but they don’t have voting rights. Generally preferred stock pays a higher dividend than the common stock of the same company, and their payments are fixed and predictable. Typically, a preferred stock’s value is driven more by the dividend it offers, than by the company’s performance. This means that preferred shares don’t move up and down in price as much as common shares.

As we said, prices of stocks go up and down. As an investor, you want to make sure you take advantage of those price movements. You want to buy a share when the price is low and sell it when the price is high. This gain is called a capital gain, and you want that gain to be as big as possible!

The key to doing this successfully is by correctly assessing a stock’s potential value. At any moment in time, a stock’s price is NOT a perfect reflection of a stock’s value.  It’s just what someone will pay for the stock at a single moment in time. A stock’s true value is essentially the unlocked potential that the stock has. If you can find a stock with lots of unlocked potential and buy it, the price of the stock will rise as the value is unlocked.

Here’s an example. The day Apple launched the first iPod, the stock price was the equivalent of $1.22. At the time, Apple was losing money and the stock looked expensive. But now Apple stock costs around 100x that 2001 price. Was Apple undervalued on that day? Absolutely. But who was to know how well Apple was going to do? Did anybody know the iPhone was coming? Or the iPad? No. But the iPod contained the seeds of massive untapped potential for Apple.

So just like buying any product, you want to calculate the untapped value in a share. And this is the holy grail of Wall Street. Everybody tries to do it. Everyone is looking into the future and making a value judgment. Wall street analysts do it, and average investors do it. Anybody can do it.

So where do you start? Start with yourself and your spending. Where does your money go? What products do you love? What products are your friends talking about? What was your last ‘Aha’ moment when you bought some truly breakthrough product? What will the world look like in 5 years? 10 years? And what companies will be the market leaders of that world?

These questions all form the basis of your stock valuation. And the difference between the price of a stock today and your perception of where it should be will determine whether the stock is undervalued or overvalued. And you want to buy the undervalued stocks and sell the overvalued stocks.

A bonus is if you find a stock that you love, but others hate. An example is Netflix when they moved from DVDs to a digital model (and raised their prices). People hated the idea and crushed the stock. But when their decision proved to be smart, and subscriber growth shot up, the stock soared.

The lesson here? Buy from the pessimists and sell to the optimists.

And this is the true value of stocks. As an owner of a smart company, you can, and should, benefit from their smart ideas and the growth that these ideas create.

Finally, you’ll need a brokerage account to buy and sell (trade) stocks. In order to open any brokerage account, you’ll have to answer a bunch of questions, and it may take some time, but it is well worth the effort.

A company can grow from a start-up in garage to a multinational conglomerate within a single generation. No other asset class allows you to piggyback on that phenomenon. And that’s why stocks can grow like no other asset class. And that is why it is so important that you learn about stocks and make them part of your life for the long term.

Just make sure you buy and hold for the ling term. Companies you believe in may encounter some bumps along the way. But a long time horizon will smooth out those bumps.

And never forget the words of Warren Buffett: The Stock Market is a device for transferring money from the impatient to the patient.