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Detail shot of an old share certificate
Detail shot of an old share certificate

Choosing stocks

The risks of stock investing Add to ...

When you invest in a stock, you could lose all of your money – in some cases, more than you invested. Before you buy a stock, understand the risks and decide if they are risks you are comfortable taking.

2 key investment risks

  1. Returns are not guaranteed – While stocks have historically performed well over the long term, there's no guarantee you'll make money on a stock at any given point in time. Although a number of things can help you assess a stock, no one can predict exactly how a stock will perform in the future. There's no guarantee prices will go up or that the company will pay dividends. Or that a company will even stay in business.

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  2. You may lose money – Stock prices can change often and for many reasons. You have to be comfortable with the risk that you might lose all of your money when you buy and sell stocks, especially if you're not planning to invest for the long term. If you use leverage to invest in stocks, like buying on margin or short selling, you could lose more than you invest.

A word about volatility

There are always ups and downs in the stock market. A stock price that changes quickly and by a lot is more "volatile”. This makes a stock riskier – you could lose a lot if you had to get your money out on short notice.

It’s not enough to just look at a stock’s volatility from day to day. You should also look at the largest monthly or quarterly loss recorded. Volatility is measured in very precise ways:

  • standard deviation – measures how widely a stock’s price has gone up and down in the past from its average price. More change results in a higher historic volatility.

  • beta – measures how the stock is doing compared to a given benchmark, such as the S&P TSX Composite Index. A beta of 1.0 tells you that a stock has been going up and down with the overall stock market. A stock with a beta between 0.0 and 1.0 has smaller ups and downs. A beta greater than 1.0 has wider price swings. Stocks with a negative beta are moving opposite to the index.

6 ways to manage risk

1. Hold a diversified stock portfolio

You may be able to reduce the ups and downs in the total value of your stock portfolio by buying stocks from companies with different features:

  • Type of industry – While companies in one industry may struggle, companies in another industry may be doing well. For example, energy stocks might slump while technology stocks are rising.

  • Company size – Investing in a smaller, newer company can offer the potential for higher growth, but it’s usually riskier than a larger, more stable company with a long history and good track record. You can reduce your overall risk by owning stock in companies of different sizes.

  • Type of stock – Preferred shares tend to offer lower risk and returns than common shares. But they pay a fixed dividend, unlike common shares. You may want to choose both for your portfolio. Learn more about common and preferred stock.

Before you decide on a stock or a portfolio of stocks, figure out how it fits with the rest of the investments you own, your overall financial goals and your tolerance for risk. Learn more about the risks of investing and how diversification can help reduce your overall risk.

2. Invest for the long term

The stock market is subject to short-term fluctuations, as well as bear markets. But over the long term, the stock market has historically performed well. If you buy stock with money that you may need soon, you may be forced to sell in a period when a stock’s price is down. If you buy high and sell low, you'll lose money.

3. Don’t try to time the market

Trying to time the market can be a risky strategy. You may hear about a stock that is climbing higher and higher in price. When more investors decide to jump in and buy the stock, they drive prices up even more. The price can fall just as fast, though, as investors start to sell to cash in on the big gains.

Other investors make the mistake of selling as soon as a stock price falls. But you don’t lose money on a stock until you sell it. If you hold on, the price may come back up. Stocks are long-term investments with many short-term fluctuations in price.

4. Get advice if you’re not a knowledgeable investor

It’s always risky to invest when you don’t understand how the stock market works, what makes a stock’s price rise or fall, or how an investment or investment strategy works. The more you know, the more you can lower this risk. If you don't feel comfortable with your level of knowledge, a qualified adviser can help you choose stocks and other investments that meet your goals and tolerance for risk.

5. Be careful about buying private stock

Some companies keep their stock in private hands instead of trading their stock publicly on the stock market. The stock is owned by a group of shareholders who can only sell their stock with approval from other shareholders. The shareholders set the price at which the stock can change hands.

Buying private stock is risky because:

  • You may not be able to buy or sell the stock when you want to.

  • You may have to make a large investment (unless you are an employee of the company).

  • It may even be a scam.

6. Be aware of the dangers of investing offshore

Canada’s securities and banking laws protect you by offering recourse through the courts if you feel you have been harmed in your investing. When your money goes to another country, you may lose that protection. If you’re approached about investing offshore, be cautious – it could be a scam.

Content in this section is provided in partnership with Investor Education Fund, a non-profit organization founded and supported by the Ontario Securities Commission that provides unbiased and independent financial tools to help Canadians make better money decisions. To find out more, go to: GetSmarterAboutMoney.ca

Follow us on Twitter: @GlobeInvestor

 

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