How to Minimize the Risks of Stock Ownership

Stocks are widely considered the best performing asset class over the long term, but that doesn’t mean stock ownership is without risk. Timing alone can account for a large part of stock market profits. Most investors, however, aren’t able to time the market and shouldn’t even try. Several other techniques are available to minimize the risks of stock ownership.

Things You'll Need

• Capital to invest
• Stock broker or online brokerage account

Instructions

1. Buy large cap value stocks. While the newest Internet startup may not be around in five years, let alone 20, many big cap stocks have already proven they're in it for the long haul. These companies may not offer the growth of some of the smaller stocks, but they’re less likely to lose everything. "Value" suggests the stocks are selling below their historical norms, temporarily out of favor possibly due to a restructuring, further suggesting limited risk.

2. Buy sound balance sheets. No matter the market capitalization of the stock, companies with low debt and high cash flow represent more sound investments than those who’ve yet to prove their profitability.

3. Hedge. A popular method of minimizing risk for more advanced investors is to use a hedge. This could mean buying a put option against a stock position, a short position in another stock, or a long position in an inverse index ETF. Inverse ETFs appreciate as an index loses value, offsetting declines in individual stocks.

4. Lock in profits. No profit is truly made until it is taken. This could mean selling all or some of a position in a company, or the selling of covered calls. This option strategy limits further upside, but offers a means of securing some income from a stock position without necessarily losing any shares.

Tips & Warnings

• Value is relative, but using objective historical factors such as P/E ratio, moving averages and dividend yield can be very helpful.

• Use covered calls after a nice run in a stock. Selling out-of-the-money strikes out a few months should take advantage of time premium decay to provide some income with minimum risk of losing the actual stock. Buying puts involves an initial outlay of capital and doesn't necessarily capitalize on time decay, but could be more effective in situations where significant downside is expected in the immediate to short term.

• Selling covered calls limits your upside and risks you will be called, losing your stock! It also only provides as much protection as the premium received for the options. Therefore, choosing which specific series to sell should be based on an assessment of downside risk.

• Owning stock involves substantial risk of loss, and no strategy can limit risk entirely. As always, consult with a professional financial planner if possible before making any investment decisions.

Resources

• Covered calls