Stocks and investment risk

Stocks and investment risk in this post we will define common stock then discuss the advantages and disadvantages.

Common stocks

A share of common stock represents a fractional ownership interest in the issuing corporation. Returns on stocks come in the form of capital growth or appreciation, and the possibility of dividends. Stocks that trade on major exchanges like the New York Stock Exchange (NYSE) and NASDAQ are easily traded and can generally be bought and sold at low transaction costs.

Advantages and Disadvantages

Over time, common stocks have outperformed almost all other financial instruments – and by a wide margin. Data shows that an investment in large-company stocks would have grown at an annual average rate of 10.2% during the years 1926-2019. Small-company stocks have performed even better, with returns of 12.1% during the same period.

Stocks have also been strong hedge against inflation over the long term, as measured by real returns. For example, if an asset returned 5% but inflation was 6%, the investor earned a negative real return (5%-6% = -1% real return). This is important because the value of money lies in its purchasing power.

If an investor received negative real returns consistently over time, at some point his or her standard of living would decrease because of the inability to buy goods and services the investor used to be able to purchase. This could take the form of having to buy cheaper goods and services, or less of them than in the past. Since no one wants their standard of living to decrease, it is important to understand the concept of real returns and to have some investments that overcome purchasing power risk.

Stocks and Risk

When considering individual stocks, there are a number of risks that must be understood. This first is called business risk. This risk is a type of unsystematic risk and it involves the unique characteristics of a company, such as its management, business plan, product line, competition, and financial strength. Deficiencies in any of these areas can lead to deterioration in cash flow than can threaten a firm’s ability to pursue growth opportunities, meet payrolls, and pay interest on its debt. Think dotcom bubble of 2000.

Unsystematic risk can be mitigated by holding a diversifies portfolio, typically of at least 15 different issues in different industries. The concept of diversification, at its simplest, means not putting all of your eggs into one basket so that a poorly performing stock is not weighted so heavily that it drags the entire portfolio down; and, hopefully, most of the other holdings have positive performance that offsets the poor performer.

Stocks and the Retirement Investor

The historic returns make common stocks – small, mid and large cap an important component in any program of long-term retirement savings and investment. Stocks, of course, fluctuate in price; and many clients find this volatility disconcerting. However, few clients can hope to accumulate sufficient funds for retirement if they are unwilling to put meaningful percentage of their portfolio in stocks.

Theoretically, the client who is years away from tapping his or her portfolio for retirement living expenses should not care about the volatility of stocks. Volatility should only matter when the client is drawing out funds or is near the point of withdrawal. For this reason, many planners recommend 40% to 60% allocation toward stocks in the early years of retirement saving, with a gradual “shifting of the mix” as retirement grows nearer.