Stock Market for Beginners

Risk is the possibility of losing money. Every investment has a level of risk. Even treasury bills, which are commonly referred to as risk free investments, have credit risk associated to the United States defaulting on their debt (highly unlikely). An investor can avoid dramatic losses and minimize the level of risk with appropriate risk-management techniques.

After determining the investment objective, risk tolerance, and time horizon for your investment portfolio, the first thing you can do to manage your risk of losing money is to allocate your funds along proper asset classes. Examples of some asset classes are cash, bonds, stocks, real estate, natural resources, and precious metals. By allocating your funds across asset classes that offer non-correlating returns, you are creating a more diversified portfolio that should smooth out returns and reduce volatility. Purchasing different mutual funds and exchange traded funds is a very cost-effective way of achieving diversification.

The second simple way to mitigate risk in an investment portfolio is to raise the level of cash by selling part or all of the portfolio. Although this eliminates upside potential, raising cash, when the outlook for a certain asset class or market is negative, can save you money and will provide you with funds to invest with later.

The third way to reduce risk when the investment outlook is negative is to reduce the level of investing on margin balances since it is volatile to do so and losses are magnified when investment values are decreasing.

When dealing with stock portfolios, there are a number of ways to use stock options to protect your capital and reduce risk. Use deep in the money call options to own stocks and exchange traded funds because they require less capital. Buy protective puts options that can protect an investment’s value when it drops below a specified point before a particular date. Selling covered calls is another options strategy that can provide you premium income that can be used to offset potential future losses.

You could also diligently place stop loss sell orders on your stock and exchanged traded fund positions. This will automatically sell your position if the stock or exchange traded fund falls to a specific price you deem critical. Inversing funds, which are relatively new, can also offset losses in certain investments by offering price appreciation in downward moving sectors or indexes.

Consistent reevaluation of personal investment objectives, asset allocation, and market outlook is essential for maintaining a healthy portfolio. Risk-management is a continuous process. Given the knowledge to protect your portfolio, your chances of surviving the next market correction or crash will increase and maybe you can even make some money when that happens.

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