Learning to Evaluate Stock Market Risks

The Equity Risk Premium: The Long-Run Future of the Stock Market by Bradford Cornell An understanding of the equity risk premium is important for informed financial decision making. Cornell's book does an excellent job tying together historical, empirical, and theoretical analysis of the premium in a package accessible to practitioners as well as academics.

So, you've finally got some money of your own, and you'd like to see it grow... perhaps standard savings offers too little growth potential, or maybe you're looking for something that offers a little more risk (and hopefully a much larger return.) Whatever your reasoning, the stock market can be a wonderful investment tool... but it helps to keep an open mind and know what to look out for.

The first thing that you should keep in mind is that the stock market isn't a tool for instant success. Yes, you can get wealthy playing the market, but that often takes a diverse portfolio, a lot of work, and years of time. It's true that a lot of people get rich off of sudden "hot" stocks, such as the "dot-com" boom of the 90's, but once the initial swell ends the stocks tend to crash. Buying the hot stocks can be exceedingly risky, since they're going to fall and fall hard in a relatively short period of time, and they're going to take a lot of people's money with them. If you must play hot stocks, keep a constant eye on them and try to sell them when they start to level off or drop.

Investors and Markets: Portfolio Choices, Asset Prices, and Investment Advice (Princeton Lectures in Finance) by William F. Sharpe Presents a method of analyzing asset prices that accounts for the real behavior of investors and makes this technique accessible through a new, one-of-a-kind computer program (available for free on his Web site, at http://www.stanford.edu/~wfsharpe/apsim/index.html) that enables users to create virtual markets, setting the starting conditions and then allowing trading until equilibrium is reached and trading stops.

Next, to help avoid risks, you need to be sure to diversify your portfolio. Now, you've probably heard this time and time again, but you might not know what it means... basically, buy a little bit of a lot of different types of stocks and bonds. That way, when one type of stock is down, another may be up and the losses will balance out. You should definitely purchase stocks in the technology sector, telecommunications, biomedical, and consumer corporations. Supplement this with precious metal and diamond indexes, and some general investment funds. Start with a few shares of a few different stocks in each of these fields, and then add to it as time goes by. You can also branch out into other areas (such as defense companies), and the base portfolio you build will help to shield your money a little bit from riskier investments that you may want to make later.

Some companies, such as Johnson & Johnson, are sometimes referred to as "safety stocks". It's a good idea to have several shares of companies such as this in your portfolio, as what they lack in large growth they make up for in consistency. These stocks rarely fluctuate and most often offer a slow and steady growth, thus giving you a strong backing in your investments.

One thing to watch out for is hearing about some stock that's "about to go big" or something along those lines. Often such tips are from disreputable sources and are for stocks that are either junk or nearly worthless. Investing in these stocks might show a decent initial return, but will most likely plummet soon after. Read the Wall Street Journal or watch the stock reports on news networks to research your stocks, and use online resources too see how they've been performing in recent weeks. Beware of the "get rich quick" schemes, as they'll often leave you much worse than you started.

Other than that, much of your investing future is up to you. Buy stock in brands and companies that you know and trust, as well as those that show promise; if the stock starts to dip, decide whether you should sell it or keep it for it's long-term potential. Reinvest dividends, since that'll give you more stock for the same initial investment, and if a stock that has been performing well in the past takes a dip remember that it could be an opportunity to purchase additional shares for a lower price. And always remember that the stock market is best used as a long-term investment, not as a way to make a quick buck.