Risk Management In The Stock Market - Are Stocks Too Risky?

There is always risk to be managed in the investments of stocks. Reward always comes with risk, and risk is always going to come with reward in the stock market. However, there are two different ways to invest in stocks, and to take advantage of that risk, each with very important differences.

The first way is to invest in individual stocks. An example of that might be in 2009, when oil is $32 per barrel and you say yourself - "I know oil is going to be $100 per barrel in a couple of years. How can I take advantage of that with the stock market?" Well, maybe at that time you decide to invest in one of the biggest and best oil companies out there. Then 2010 rolls around and an executive of that company makes a huge blunder, creating an ecological disaster in the Gulf of Mexico unlike anything ever seen. Your investment in British Petroleum--instead of tripling--goes to nearly zero, as it pays for clean up and the losses, etc. History is littered with examples such as this. Take the case of Enron; it might be an executive who does something illegal at that company. On the other hand, it could be something completely out of their control--such as the large earthquake that struck Japan in 2011, forcing Toyota to shut down its manufacturing facilities for 6 months.

Now, there are many ways to invest in the stock market other than one company at a time. You can buy the entire industry of, say, 50 oil companies. But why stop there? Why not buy the entire market? You can do that in a very inexpensive manner, and still get the returns of the overall market from your investment, but without accepting any individual or industry-specific risk. The academic evidence will tell us that the superiority of this approach is really a no-brainer.

But that doesn't mean there wont be ups and downs. The cost for getting the upside of the overall market is taking on the volatility of the overall stock market. The clearest example of this stock market volatility without a doubt is the past 13 bear markets that this country has experienced since World War II. That equated to investors losing about a third of their overall wealth in the stock market, roughly every five years. What was the reward for taking on all that volatility? Well, if you had invested $1,000 in U.S. stocks right after World War II , your investment would be worth about 1 million dollars today. Thats the reward for taking on volatility of the market. Risk and reward go hand in hand.