Oran Hall | Risks and rewards in stock investments
QUESTION: I have previously purchased shares on the Jamaica Stock Exchange but the performance of the stocks has declined. Is there any sound financial advice for me?
FINANCIAL ADVISER: The decline of stock prices is to be expected. Stock prices do not move in a one -dimensional way they increase and they decrease. Investing in stocks comes with risk. There are two types market risk, also called systematic risk, and specific risk, also called unsystematic risk. This is why it is important to take steps to manage risk.
Market risk refers to the risk of incurring losses due to factors which affect a market. So a stock price declines due to the overall decline of the stock market. When the stock market declines generally, even the best stocks record price declines. It is just that the better stocks tend not to decline as sharply as lesser quality stocks.
By the same token, when the stock market is experiencing positive price movement, even lesser quality stocks record price appreciation but generally below the level of the better stocks.
With reference to the stock market, specific risk is that associated with a particular stock. The price of the stock moves because of issues specific to the listed company. For example, consumers may choose to switch demand to a competing product or internal problems may lead to the profits of the company declining. Diversification is the primary tool for managing specific risk.
There is sufficient evidence to show that stocks perform very well over the long term. Short-term fluctuations are to be expected and investors who do not have the capacity to tolerate them are those generally acknowledged to be risk adverse, or low-risk takers at best.
To protect yourself, you should diversify: invest in several stocks in different sectors of the economy as they will not all be affected in the same way by developments in the market or economy. It is advisable to structure your portfolio to include financial instruments from more than one asset class.
This may moderate the fall in the value of your portfolio when the stock market, for instance, declines, but it may also moderate the appreciation in the value of the portfolio when prices are increasing.
SUPPLY AND DEMAND
In any case, stock prices are determined by demand and supply. Prices rise when demand is higher than demand. Conversely, prices fall when supply is greater than demand. In the regular course of trading, there are times when investors will choose to realise their gains and this profit-taking often results in supply outstripping demand, leading to the decline of prices.
But this does not go on forever. Prices eventually bottom out and buying becomes buoyant again and prices improve as demand exceeds supply.
The solution is not to sell when there appears to be a weakening of demand. This is often a short-term situation and it is often difficult to repurchase those stocks at the lower price.
Additionally, the regular buying and selling of the same stocks may work against the investor who must pay the charges associated with each buy and sell transaction, and thus see a dilution of the gains from investing.
In fact, many long-term investors tend to take advantage of declining prices to reduce the average cost of their stocks by buying more, but this should be tempered by the need to ensure that a portfolio does not have too much of one instrument or type of instrument.
If you have a portfolio of good stocks in a balanced portfolio, I see no need to be unduly concerned by the decline of stock prices if you are investing for the long term.
Of importance is that you select the stocks of companies that consistently deliver strong financial performance and that are able to withstand competition and the vagaries of the economy.
The key to this is good research and the removal of strong emotion from the decision-making process. You should determine why you want to invest and possibly when you will likely need the money. It would not do much harm to have an exit strategy, which could be when a certain return is achieved or when the time set for the funds to be used is reached.
Bear in mind that capital gains is only one element of the yield from stocks. Most pay dividends which, I must admit, are not generally very generous but they do add up over the long term and can make a meaningful difference to the yield of your portfolio.
Take the long-term view. If you are primarily investing for the short term, the stock market is not the place to be. Sometimes quick returns come, but this should not be seen as the norm. If you make good selections and are patient, you can reap good rewards.
- Oran A. Hall, principal author of 'The Handbook of Personal Financial Planning', offers personal financial planning advice and counsel. Email firstname.lastname@example.org