Individual investments can be usually summarised in two words – “Returns” and “Risks.” The typical thumb rule says the greater the potential reward, higher the risk. Unfortunately, the rule doesn’t stand true in reverse order. Many a times, greater risk is simply great, without any potential of high return. Taking risk 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 the market condition sours, stocks, mutual funds, bonds or exchange-traded funds, be it any investment platform, all lose value. If market crashes, it may lose a lot of its value. Even conservative insured investments such as Certificates of Deposit (CDs) 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 and make sensible financial approaches.
Buying overvalued stock
Overvalued is a term used to describe stocks with current price too high for its fundamentals and is not justified by its earnings outlook or P/E (price/earnings) ratio. These stocks are most perceptible to drop in price and therefore not good investment options. There are two ways in which stocks may become overvalued. First, it may be overvalued due to a sudden surge in demand, which is primarily driven by investors’ 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 and balance sheet decline while its market price remains constant. Overvalued stock in most cases experience a price slump and returns to a level where it reflects its financial fundamentals and status correctly. Overvalued stocks are not counted as good buy and should be avoided while making investments.
Co with poor corporate governance
Corporate governance is among the critical determinants of stock price. Corporate governance score is an independent variable while company’s share price is a dependent variable. Better managed firms function better and have more consistent outputs compared to firms with poor corporate management system. As a result, firms with higher corporate governance standards have higher stock prices and vice-versa (in terms of multiples). Strong governance determines stability of the organisation and makes them a better buy. Studying the 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
Investment by default carries some amount of risk factor along. Making investment in a company that you don’t know fully only makes the magnitude of risk higher. Factors like financial performance, organisation’s track record, business costs, leadership, risk factors and dividend history have to be analysed before putting your money in any business or company. How a company’s management functions and how it manages its money flow says a great deal about how its stock gets priced in the market. So, before you decide about investing in any company, ask these following questions:
Invest only if the answers of above questions come positive.
- 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?
- Is there any sign that the firm is losing money? The best way here is to view the cash flow statement.
- What is the company’s corporate governance history?
Evaluate companiesA lot of people take investment as poker pot. You throw money in the bet and wish to magically become rich overnight. That’s not how investments work. It is rather a very well thought and calculated method of money multiplication provided you are applying sufficient analytics to it. Random stock purchase translates to huge risks. Picking stocks of companies you understand will always give you an upper hand in the 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. As Warren Buffett puts it “You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.” However, your knowledge of a particular industry should not be your excuse of not researching the organisation thoroughly. Your inside knowhow of the company you are putting your money on will make you realise that investing is not just lucrative, but also a great fun.
Investing in a stock on hearsay
In today’s scenario, rumour mills work overtime and market reacts instantly to it. The media is more active than ever and this makes news flow quickly. The downside of the situation is that many a time the announcements are not originated from legit sources. As an investor you should know the difference between confirmed and unconfirmed news and verify before buying certain shares. 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. Investment is not a gamble, it is a pure mathematics and probability. Nurture it with skills and experience and you will establish well in the industry in no time.
The author is founder of Prudent Equity. The views expressed in this article are his own