Let’s admit it, after the 2008 financial crises, most people have become risk averse. Most people are too scarred to invest in the stock market for fear of making huge losses. For many, the stock market is too risky. This has led to many people holding cash rather than investing. And if they do invest, they are doing so conservatively. If you followed this conservative approach, you will have missed out of gains upwards of 20% per annum since the financial crises. Can you really afford to miss out on these types of gains?
Investing in the stock market will give you higher gains than most other asset classes including property. Just look at this article I wrote comparing returns of different asset classes in the UK.
Investing in stocks is risky but by taking the rights steps, these risks can be minimised. Here are 5 steps to take that will help you negate the risk of stock market investing:
1. Invest in a broadly diversified portfolio of low cost ETFs and index funds
Costs are one of your biggest pitfalls when it comes to investing. And they can be expensive too. Just like how returns compound over time, so too does costs. So it is imperative as a first step to pick a platform with low costs.
As well as having low costs, you also want to invest in Exchange Traded Funds (ETFs) ad index funds. These instruments allow you to track the market and gives you instant diversification. Research has shown that by buying low cost index funds, you are more likely to perform better than investing in an open ended fund or a mutual fund.
Don’t aim to beat the market, instead participate in it – This goes hand in hand with point one above. It is import to know that virtually no one goes through a bull market and a bear market and comes out better than an index fund.In trying to beat the market, investors usually underperform and this could end up costing them money.
2. Don’t time the market; Pound cost average instead
When buying Index Funds/ ETFs or even shares for that matter, it is best not to time the market. Rather than timing the market by buying a large chuck of shares at once, you can buy a shares for a set value each month. This allows you to smooth out fluctuations and you will be buying more shares when prices are low and less shares when prices are high. Many of the big brokerage companies or fund platforms encourage this monthly investing plan. And the cost of investing this is way is only £1.50 per trade which is really cheap.
3. Understand valuation ratios
In investing, it is imperative to understand valuation ratios. Valuations help you by ensuring you don’t buy shares at the top of the market.
One of the best valuation ratios to use is the P/E or Price to Earnings Ratio. Now different stock markets have different benchmarks so you’ll need to do your research. For example, for the FTSE, the historical P/E ratio has been 14 so any time the ratio is below this suggest a good time to buy. And anytime the ratio is above this suggests that is might not be the best time to buy.
For US stocks, the historical P/E has been 15.5.
See how to value the overall stock market to learn more about P/E ratios and historical averages for various stock markets.
Use valuations in conjunction to pound cost averaging above. This is because no one can know the top or the bottom of the market. But when the current P/E ratio is below the historical norm, this suggests a good time to buy and you should make an extra effort to purchase shares at this time.
4. Use robo-advisers or technology enhanced platforms
Technology in the past couple of years has greatly affected the field of investing. And it has done so for the better. Just have a look at this article on the future of investing. Technology has made it easier and cheaper than ever to invest. Innovation in this field has been so dramatic that your whole portfolio can be managed for you according to your risk preference at a fraction of the cost professional managers charge. One such platform that is leading the way in UK is Nutmeg.
Nutmeg creates portfolios based on your risk preference and your time horizon. All you have to do is is answer a few questions to determine your risk profile, pay in your money and the Nutmeg team will take care of the rest. They will create and manage a portfolio for you all for a maximum cost of 1%. Have a look at the article I wrote on nutmeg here.
5. increase for your time horizon
If you intend to invest money for less than 3 years, don’t bother investing (consider trading instead). For me personally, I would increase that 3 years to 5 – 7 years.
Markets are unpredictable and investing for a short amount of time only exacerbates this problem. Investing with a short time horizon is difficult and risky because short-term pricing of stocks is unpredictable. Stocks sometimes go up or down for no apparent reason, mainly due to the trading activities of various individuals, entities and algorithmic traders. A stock that sets record earnings but misses people’s expectations by a few pennies could fall several percentage points. Likewise, a company that lays off hundreds of employees can shoot up in price. If one selects the type of companies described above and holds them for significant periods of time (many years), the effects of these seemingly random factors will be mitigated.
Long-term investors are much more likely to see their investments grow over time than market timers or those who invest for five ye ars or less