MINIMIZING STOCK-SPECIFIC RISK in Software

Draw GTIN - 13 in Software MINIMIZING STOCK-SPECIFIC RISK

Obviously, the way to minimize stock-speci c risk is to invest in a plethora of di erent companies You can do this easily with a diversi ed stock mutual fund, since the average fund invests in hundreds of di erent stocks Conventional wisdom used to say investors needed to own about two dozen stocks to achieve adequate equity diversi cation But new academic research seems to indicate that investors need exposure to around 50 stocks to adequately minimize company risk Keep in mind also that those 50 or more stocks should be spread out among a multitude of sectors of the economy, since stocks within the same industries tend to move in relative correlation with one another It s important also to balance your portfolio, if you do choose to diversify for defensive reasons, among di erent types of stocks large and small, growth and value, and domestic and foreign as we will discuss in a moment

With all of these risks, why does anyone invest in stocks The rst response goes back to what we discussed at the start of this chapter: Stocks, over the long run, are the best-performing asset you can put your money into But it s important to note that this won t necessarily be true if, fearing market risks, you pull your money out of stocks and miss even a handful of the best trading days in the market Now, there are some talented investors who feel they can beat the market by timing these decisions and trading strategically and frequently If you don t feel you can do that with success, then staying in the market but in a diversi ed and conservative manner would appear a decent alternative For example, between August 1982 and August 1987 the S&P 500 averaged annual gains of more than 26 percent But if you were out of the stock market for just 20 of the best trading days that the S&P 500 enjoyed during that stretch, your returns fell to 131 percent And if you missed out on the 40 best days during this bull market, you d have generated returns of only 43 percent Investors experienced the same results in the 1990s bull market Those who were on the sidelines for the best six-month stretch between 1992 and 2001 enjoyed annual returns of only 8 percent, whereas equity investors who stayed in the market at all times enjoyed double-digit gains on average every year (Figure 5-3)

Fig 5-3 Risk of Not Being in the Market Investors who missed out on even a handful of the market s best days have wound up losing tremendous amounts of gains over the long run

Time Period 8/82 8/82 8/82 8/82 8/82 1/92 1/92 1/92 1/92 1/92 to 8/87 to 8/87 to 8/87 to 8/87 to 8/87 minus minus minus minus 10 20 30 40 best best best best days days days days

S&P 500 Annualized Returns 263% 183% 131% 85% 43% 129% 122% 114% 105% 80%

to 12/01 to 12/01 to 12/01 to 12/01 to 12/01

Being out of the market is particularly damaging during what are known as in ection points for stocks These are those points in time when market trends reverse and we go from a bear market to a bull, or from a correction to a rally Since the start of World War II, people who have been invested in the market during periods of market recoveries have enjoyed returns of more than 32 percent, on average, in the rst year of such rallies But if you were to miss just one quarter (three months worth) of that rst-year rally, your average gains would be cut by more than half