How to manage risks when investing in the stock market

Investing in stocks is one of the best ways to generate higher returns in a low interest rate environment. However, stocks are risky and because of this, many Filipinos do not even want to consider buying stocks as an investment option.

The good news is, there are ways to manage risks, allowing everyone to take advantage of the higher returns generated from investing in stocks.

Here are some of the best ways to manage risks when investing in stocks:

Invest for the long term. Studies show that in the short term, potential losses from investing in stocks can be very daunting, reaching double digits sometimes. However, studies also show that losses diminish over time. In fact, those with investment time horizons of 20 years and over always generate positive returns that are higher than returns generated from investing in bonds.

Given these findings, risk-averse Filipinos who want to invest in the stock market should only use money they will not need in the short term. This could include funds for retirement. Personally, I invest the money that my children receive during Christmas or their birthdays because they won’t need these funds until they start their own families.

Diversify. The saying “don’t put your eggs in one basket” applies when investing in the stock market. Don’t just buy one or two stocks. After all, there are many companies that were doing very well in the past that are significantly less profitable today or no longer exist because of disruptions brought about by numerous factors including technology.

An easy way to diversify is by buying mutual funds or unit investment trust funds (UITFs) that are focused on investing in the stock market. These funds are diversified because the asset management companies that manage these funds pool the money of several investors, which they then use to buy a basket of stocks. Because of this, even if you can only afford to invest a few thousand pesos, your exposure in the stock market is already diversified.

Avoid buying stocks based on tips. If you have a high risk tolerance and can stomach the volatility that comes with trading stocks, avoid buying stocks based on tips. Admittedly, it is very tempting to buy speculative stocks because they have the potential to go up quickly, allowing you to earn a significant amount of money in a short amount of time. However, speculative stocks can also go down as fast as they go up and investors can encounter difficulties exiting because when prices are falling, there is usually a stampede of sellers who want to avoid holding a stock that can become worthless.

Don’t use borrowed money. Another way to enhance returns is by borrowing money to invest. This is a strategy that is available for stocks (through margin loan), and is popular for investors trading forex and commodities (through leverage).

Although using borrowed money to invest magnifies returns when prices go up, it also magnifies losses when prices go down. Using borrowed money also heightens the risk of losing 100 percent of your capital, and when this happens, it will be very difficult to recover your losses.

For example, recall that prices of stocks went down sharply in March 2020 because of the pandemic. If you owned stocks that were bought on margin, your stockbroker would have asked you to reduce or fully pay your margin loan. If you were not able to comply, your stockbroker would have sold your stocks to pay for your debts.

Since your stockbroker sold your stocks at a very low price, you most likely lost a significant portion of your capital. You would have also lost the opportunity to participate in the stock market’s rebound from its March 2020 low to where it is today. INQ