Individual investments can be usually summarised in two words – returns and risks. The typical thumb rule says, the greater the potential reward, higher is the risk. Unfortunately, the rule doesn’t stand true in reverse order, which means greater risks does not essentially translate into higher potential reward. Sometimes, greater risk is simply greater risk, without any potential of high return.
Taking risks is part and parcel of investing; however, it is necessary to understand what kind of risk you should be willing to take and how to repress unacceptable risks.
All investments gestate some degree of risk. When market condition sours, stocks, mutual funds, bonds all loses value. Even conservative insured investments like certificates of deposit) that are issued by banks or credit union, comes with inflation risk. Using the following guide, you will be able to understand various risk factors and how to avoid these traps.
Buying an overvalued stock
Overvalued is a term used to describe stocks with current price too high for its fundamentals. It may be overvalued due to a sudden surge in demand, which is primarily driven by investor’s anticipation. If this price hike is not justified by the company’s actual financial status as extracted from its fundamentals and growth prospects, the security is considered overvalued.
Another way through which stocks may become overvalued is when its fundamentals such as revenue, growth projections, earnings, balance sheet, etc. decline while its market price remains constant. Overvalued stocks are not counted as good buy and should be avoided while making investments.
Company with poor governance
Better managed firms function better and have more consistent outputs compared to firms with poor corporate management system.
Strong governance determines stability of the organisation and makes them a better buy. Studying company’s corporate governance history will help you judge whether making an investment in the firm is a good move or a pitfall.
Investment without knowing the firm
Investing in a company that you don’t know fully about, only makes the magnitude of risk higher. Factors like financial performance, organisation’s track record, business costs, leadership, risk factors and dividend history, has to be analysed before putting your money. Before you decide about investing in any company, ask these following questions:
* Has the company created value for its shareholders and shared the profits with them?
* Is the company investing its spare cash wisely for its future endeavours or is there misallocation?
* Does the balance sheet have sufficient strength to be able to cover short-term debts or liabilities?
Invest only if the answers of above questions come positive.
Outside one’s circle of competence
Picking stocks of companies, you understand will always give you an upper hand in investment market. Not only you will have better understanding of the business, you will have more confidence in your investment pattern and you will be able to better analyse the future drift in stock price. Your knowledge of a particular industry should not be your excuse of not researching the organisation thoroughly.
Investing on hearsay
Rumour mills work overtime and market reacts instantly to it. As an investor, you should know the difference between confirmed and unconfirmed news and verify before buying certain shares.
At times, fake websites resembling similar authentic investment portals do these announcements to get investors put their money on certain firms.
Before rushing into any such deals, take some time to confirm the legitimacy of such declarations to save yourself from getting conned.
If you play on investment with some logic, there is no better moneymaking game than this. The thrill of risks makes you more attentive and grooms your anticipation skills.
Investments is not a gamble, it is pure math and probability. Nurture it with skills and experience and you will establish well in the industry in no time..
The writer is founder of Prudent Equity