Stock market investing can be extremely safe and conservative, or it can be a reckless chase of the big money. It depends on the investment strategy that you use.
Typically, the more you diversify your money across different companies, the less risk you will be taking. The type of company that you choose to invest in also plays a part in determining the riskiness of your investment.
It’s wise to choose the level of risk that matches your level of ability as an investor. I go into more detail on this topic in this video.
HOW DIVERSIFICATION AFFECTS YOUR RISK
At one end of the spectrum of risk is to bet all your money on a single stock. If that company does well, you’ll make great returns. However, there’s always a chance that the company could go bust. You might lose all of your money.
At the other end of the spectrum is extreme diversification. With this method, you are placing a small fraction of your money into a lot of different companies.
This way, if one of those companies goes bust, you will only lose a small fraction of your money, while the rest continues to grow. Of course, if one company does extremely well, you will also miss out on a lot of those returns. Remember, though, that you don’t know which company is going to do well.
HOW THE TYPE OF COMPANY AFFECTS YOUR RISK
To diversify your money, you can invest with an index fund. The ASX 200 is an example of an index fund that spreads your money across 200 of the biggest companies in Australia, measured by market capitalization.
The market capitalization of a stock is its price per share multiplied by the total number of shares. This indicates what the total company is worth.
By going with an index fund like the ASX 200, you are lowering your risk. Bigger companies are typically more stable and more likely to succeed.
Startups are typically riskier and their failure rate is much higher. That said, you can get index funds in more risky stocks as well. This is riskier than investing in bigger companies, but less risky than placing all your money with a single stock.
ONE SIZE DOES NOT FIT ALL
Warren Buffett is the world’s greatest living investor. Surely he would know how much is the right amount of risk to take in the stock market?
With Warren Buffett, it’s actually a case of “do as I say, not as I do.”
Personally, he does not invest in index funds and he does not even practice diversification. He puts the majority of his money in a few individual companies. There have been times when he has bet half of his entire net worth on one single stock.
However, Warren Buffett is a stock market insider like no one else. He has been involved in the stock market with great intensity since he was age 10. Now, he is nearly 90.
Warren Buffett’s advice for the average investor is to practice extreme diversification. If you don’t have the expertise, make up for it with diversification. Index funds are the vehicle for that.
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