How to minimize your stock investing risk

Now, before you go crazy thinking that stock investing carries so much risk that you may as well not get out of bed, take a breath. Minimizing your risk in stock investing is easier than you think. Although wealth building through the stock market doesn’t take place without some amount of risk, you can practice the following tips to maximize your profits and still keep your money secure.

Gaining knowledge

Some people spend more time analyzing a restaurant menu to choose a $10 entree than analyzing where to put their next $5,000. Lack of knowledge constitutes the greatest risk for new investors, but diminishing that risk starts with gaining knowledge. The more familiar you are with the stock market — how it works, factors that affect stock value, and so on — the better you can navigate around its pitfalls and maximize your profits. The same knowledge that enables you to grow your wealth also enables you to minimize your risk. Before you put your money anywhere, you want to know as much as you can.

Staying out . . . for now

If you don’t understand stocks, don’t invest! I think that some measure of stock investing is a good idea for most people. But that doesn’t mean you should be 100 percent invested 100 percent of the time. If you don’t understand a particular stock (or don’t understand stocks, period), stay away until you do understand. Instead, give yourself an imaginary sum of money, such as $100,000, give yourself reasons to invest, and just make believe. Pick a few stocks that you think will increase in value and then track them for a while and see how they perform. Begin to understand how the price of a stock goes up and down, and watch what happens to the stocks you chose when various events take place. As you find out more and more about stock investing, you get better and better at picking individual stocks, and you haven’t risked — or lost — any money during your learning period. A good place to do your “imaginary” investing is at Web sites such as Marketocracy (www.marketocracy.com). You can design a stock portfolio and track its performance with thousands of other investors to see how well you do.

Getting your financial house in order

The bottom line is that you want to make sure that you are, first and foremost, financially secure before you take the plunge into the stock market. If you’re not sure about your financial security, look over your situation with a financial planner. Before you buy your first stock, here are a few things you can do to get your finances in order:

Have a cushion of money. Set aside three to six months’ worth of your gross living expenses somewhere safe, such as in a bank account or treasury money market fund, in case you suddenly need cash for an emergency.

Reduce your debt. Overindulging in debt was the worst personal economic problem for many Americans in the late 1990s. The year 2001 was a record year for bankruptcy, with nearly 1.5 million people filing for bankruptcy.

Make sure that your job is as secure as you can make it. Are you keeping your skills up to date? Is the company you work for strong and growing? Is the industry that you work in strong and growing?

Make sure that you have adequate insurance. You need enough insurance to cover you and your family’s needs in case of illness, death, disability, and so on.

Diversifying your investments

Diversification is a strategy for reducing risk by spreading your money across different investments. It’s a fancy way of saying, “Don’t put all your eggs in one basket.” But how do you go about divvying up your money and distributing it among different investments? The easiest way to understand proper diversification may be to look at what you should not do:

Don’t put all your money in just one stock. Sure, if you choose wisely and select a hot stock, you may make a bundle, but the odds are tremendously against you. Unless you’re a real expert on a particular company, it’s a good idea to have small portions of your money in several different stocks. As a general rule, the money you tie up in a single stock should be money you can do without.

Don’t put all your money in one industry. I know people who own several stocks, but the stocks are all in the same industry. Again, if you’re an expert in that particular industry, it could work out. But just understand that you’re not properly diversified. If a problem hits an entire industry, you may get hurt.

Don’t put all your money in just one type of investment. Stocks may be a great investment, but you need to have money elsewhere. Bonds, bank accounts, treasury securities, real estate, and precious metals are perennial alternatives to complement your stock portfolio. Some of these alternatives can be found in mutual funds or exchange traded funds (ETFs). Okay, now that you know what you shouldn’t do, what should you do? Until you become more knowledgeable, follow this advice:

Only keep 20 percent (or less) of your investment money in a single stock.

Invest in four or five different stocks that are in different industries. Which industries? Choose industries that offer products and services that have shown strong, growing demand. To make this decision, use your common sense (which isn’t as common as it used to be). Think about the industries that people need no matter what happens in the general economy, such as food, energy, and other consumer necessities.