What is investment risk explained

Investment Risk Explained

What is Risk?

We are often told to take risks in life, but what does risk mean when it comes to investments? Risk is defined as a source of danger or possibility of incurring loss or misfortune. For example, you are taking a risk when you decide to go out the night before a big exam instead of study. You might end up failing your exam.

At first, risk sounds entirely unnecessary. Why would you do something that could possibly lead to misfortune? When you take a risk, you are not just setting yourself up for a possibility of failure, but you are also setting yourself up for the possibility of something extra.

You took the risk of failing your test so you could have a good time going out the night before. If you did not take that risk, you might have spent the time studying, but you wouldn’t have been happy staying home.

What does risk have to do with investing?

Risk plays a huge role in investing. An investment can be risky to varying degrees or risk-less. Risk-less investments are those investments backed by the governments such as government bonds or and FDIC insured savings account. Because the government backs them, you are guaranteed to get your money back. The only problem with risk-less investments is that you usually won’t get a very high return.

You have to take a risk to get a higher return which is why there are risky investments. The higher possible return on the investment, the riskier it is. The riskier the investment, the less likely you will get a return at all or even your principle investment back for that matter.

Why buy risky investments if you might not get it back?

Simple answer, a riskier investment gives a higher return. Sure, there’s a chance you might not get your money back, but that’s why you need to research your investments and weight the risks.

If you notice there are bonds for sale that offer 25% interest for a new start up company, you can’t just buy it and think “Well, I might get my $1,000 back and if I do I’ll get $1,250 back.”

Look into the company. Does it show promise? Do they seem like the’yre the kind of people that will pay you back? 25% interest is very high for a bond which would make it very risky.

On the other hand, there might be a bond that promises 8% interest from a company that has been around for a while and that you may have bought from before. Should you invest your $1,000 in this company for 8% or stay save and invest in a government bond for 4%?

This is where you need to way the risk. You decide if it’s right for you. Remember that if you don’t take any risks, you will continue to get a small return. The stock market is full of risk. You could invest in the stock market for the next 50 years and get a low historical average of a 10% return, or you could stay safe and invest in 4% interest government bonds.

Taking a little risk could mean thousands or even millions of dollars for you.

Should I always take the risk?

Generally, if you are young, take more risks, if you are older and nearing or in retirement, take very little risks. As a teenager or someone in their 20s, if you lost $25,000, you still have 20 to 30 years to get it back. If you lose that money when you are 65, you could be cutting into your living expenses in retirement.

Understand your risk and don’t always take the safe route. Take the risk and you could end up enjoying a much richer retirement sooner because of it.

Understanding Margin Trading

Understanding Margin Investing

Almost all stock brokerage firms offer margin trading, which is essentially borrowing money from them to purchase more stocks. Many investors do not understand margin trading or whether or not it is good for them.

Deciding whether or not to borrow on margin is a business decision like any other. When you borrow on margin, you are borrowing money to buy stocks, using the stocks you currently own as collateral. If you think the stocks you will buy will significantly outperform the margin rate you pay, then borrowing on margin may be good for you.

Why Use Margin When Trading?

For example, let’s say you have a very large asset base, let’s call it $10 million. You believe the market is incredibly oversold, as it was a couple weeks ago. You want to borrow money to invest in the market. Deciding to borrow $2 million, paying 5% interest. You believe that you can make 15-25% on the money you borrow, well above the interest rate you are paying. In this case, borrowing the money on margin looks like it will make a good payoff.

As you can see, the three key factors here are the margin rate you are paying, the amount you can make off of the money you borrow, and your risk tolerance. The above example, however, is a very optimistic one. Most of the time, for people with average or small asset base, margin rates are very high, generally 8.5% or more and can easily be 10% or more. Furthermore, the market returns about 10% a year on average, so most of the time, borrowing on margin mean taking on a lot of risk for potentially very little reward.

Margin Trading Risks

What exactly are the margin risks? Well, besides the fact that you are betting more money, so you can lose more money, you also risk a margin call. Let’s say you have $50k and borrow $50k on margin. The market gets pummeled, and your $100k in total investments ($50k yourself plus $50k you borrowed) drop down to $70k. At this point, there’s a very good chance you’ll receive a margin call. The broker will demand that you sell securities (or put up additional funds) so that you reach a certain level. For example, the federal government requires brokers to have at least a 25% maintenance requirement, though most brokers have a higher number.

Let’s say your broker has a 30% maintenance requirement. Since you borrowed 50k on margin, you will need to maintain an overall balance of about $71k or more before receiving a margin call. If you get a margin call, you will need to put up more money from your bank account or start selling securities.

Let’s say, in the $50k +$50k example that you’re somehow forced to sell all of your securities after your balance dropped to $50k. Now, all you have is $20k minus what you paid in margin interest. Even though the market only dropped down by about 30%, you ended up losing over 60% of your funds since you leveraged yourself.

As you can see, margin trading involves a lot of risk. It should only be done by expert investors who know what they are doing and can get access to a decent margin rate. For average investors, margin trading is generally a bad idea.

What Is DRIPs Dividend Reinvestment Plans

What Are DRIPs? – Dividend Reinvestment Plans

DRIP stands for Dividend Reinvestment Plan. Sometimes you have the option to participate in a Dividend Reinvestment Plan, or DRIP, when buy stock in a company. It is very simple. When you buy a stock you can choose to have all the dividends reinvested in the stock.

For example, let’s say you buy some stock from CVS. If you buy 20 shares of stock and they pay dividends of $.50, you will receive $10 in dividends. Instead of paying you, they will automatically reinvest it and buy you more stock. If they stock cost $20 per stock, they will buy you ½ of a share of the company.

How can you participate in DRIPs?

Some stock brokerage firms will give you the option to participate in DRIPs through them. With fidelity, they will automatically reinvest your dividends for you in more stock.

You can also participate directly with the company. You can send a check directly to the company and pay much smaller fees. It is also better because you don’t need to buy a large amount of stock shares, you can start very small sometimes as low as $100.

For example CVS’s plan of how to invest directly to a DRIP, see CVS’s plan here. With this plan, there is not transaction fee for the reinvestment of dividends.

Why should you use a DRIP?

Investing in DRIPs is a great way to start investing when you have little money. You can invest $100 in a company directly and watch it grow through capital gains and reinvested dividends. By reinvesting dividends, you will also receive more shares.

Some plans require you to own one share of stock to start. If you are investing directly, it is easiest to just buy a share online through sites such as oneshare.com or singleshare.com. You can also purchase these as gifts for children.

If you are interested in investing and you don’t want to have to invest $1,000 or more to start, you should consider participating in a DRIP. You can also invest very inexpensively through fidelity.com. Their commissions are on $4.95 per transactions and you can invest as little as you want.

Give it a try and start making money! If you are under 18, you should talk with your parents for help.

What Is A Money Market Fund

What Is A Money Market Fund?

Money market funds are very similar to mutual funds. With a mutual fund, your money is pooled with other investor’s money and it is all divided among many different investments.

Money market funds are the same, except the money is invested in government securities. They are not federally insured like general savings accounts, but they are lower in risk than regular mutual funds.

What types of securities will my money be invested in?

Money market fund accounts invest in highly liquid and low risk securities. Liquid means that it can be taken out very quickly. A savings account in your bank is highly liquid because you could go to the bank and take out money right away. Real estate has low liquidity because it would take time to get the money back that you invested into it.

The government securities that they invest in are usually certificates of deposit (aka CDs), commercial paper of companies, and other short term investments. In the U.S. these funds are regulated by the Securities Exchange Commission or SEC.

How do Money Market Funds work?

The value of a money market fund is always $1. The value doesn’t fluctuate like a share of stock, it earns interest similar to a bond. The securities always include short term bonds that reach maturity in 90 days or less. This allows for low risk.

If you are interested in investing in a fund, I would suggest a traditional mutual fund. They are higher risk, but can probably earn you more money. If you are interested in low risk government securities and don’t have a lot to invest, I suggest going for government bonds.

What Are Dividends - Stock Dividends

What Are Dividends – Stock Dividends

If you are new to investments, you may or may not know what dividends are. Hopefully you understand what a stock is and how it makes money. It is simply a piece of a company that you can own. Let’s say a company has 1,000,000 shares of stock that cost $10 each. You can purchase 10 shares for $100 dollars.

How do you make money from stocks?

Over time, the value of these shares of stock may increase or decrease. This is based on the supply and demand principle of economics. As more people want to buy stock from a particular company, the price of that stock increases. The reverse happens when more people are selling their shares, the price goes down.

Where do dividends fit into all of this?

When a corporation is doing well, they may decide to pay dividends. This is a payment to their shareholders separate from stock increases. The increase from their stock doesn’t come from the corporation, but the dividends do.

The amount of dividends depends on the corporation’s net income and how much they are willing to pay. It could be anywhere from $.25 to $1 or more per share. So, if you have 100 shares of stock of a company and they decide to issue $.50 per share in dividends, you will make an extra $50. This is usually done on a quarterly basis.

Should you search for dividend paying stock?

Some companies almost always pay dividends. These stocks are popular among retirees because it is another source of income. Whether or not you look for dividend paying stock is entirely up to you.

I wouldn’t suggest you buy stock only based the fact that they pay dividends. You should conduct proper research of any company you are willing to buy stock in and there is no problem making dividends one of your criteria.

Of course, if you are young, you have more time and can take more risk. Many of the younger companies don’t pay dividends because they are still becoming established, but they might give you a much higher return.