If you're diving into the stock market, be aware of what "risk" really signifies. You're not just risking a loss on a stock; risk also means taking a chance of not earning enough from the market to keep pace with inflation. In this game there are two basic and very different approaches to evaluating a company and the risk of buying its shares.
Value vs. Growth
Stock investors fall into two broad categories: value and growth. A value investor is looking for bargains: stocks that are priced at less than their true value when you take into account the company's earnings and future prospects. Growth investors are less interested in stock price. They want companies that are successful and making money, or those with a hot product or business model that other investors are rewarding with a high stock valuation.
Value: The Risks
There's an important investment theory known as the "efficient market hypothesis," holding that all available information is already priced into stocks and the market. Therefore, there is no use in trying to outsmart the market by digging for undervalued stocks -- they're already fully valued by investors, who as a community possess all the relevant knowledge concerning assets, earnings, debts and the like. This would be bad news for value investors, who are essentially trying to get into stocks before they are "discovered." The risk is that a stock is undervalued for a good reason, that the market collectively recognizes that fact, and that the price is bound to stay low forever. Therefore a value investor risks putting money into a stock that goes nowhere, locking up capital that could be earning a much better return somewhere else.
A growth investor believes in companies that are already successful and are being rewarded by a stock price that is high relative to earnings. The basic measure of this is the price-to-earnings ratio, which shows the stock price as a multiple of the company's net earnings. A high P/E means high growth generally -- but also higher risk. If a stock's P/E stands at 50 but the company is growing earnings at only 10 percent a year, the market is showing some wild optimism that growth will not only continue but accelerate. A single bit bit of negative news, a competitor's sudden appearance on the scene, one worse-than-expected earnings report -- any or all of these events can knock a growth stock down, and quickly.
Returns also depend on the relative size of the company you invest in, with "small-cap (for capitalization)" stocks carrying a higher risk and reward. A study reported by Fidelity.com found that over a 30-year period from 1980 until 2010, "mid-cap" value stocks outperformed their growth-oriented counterparts, returning 13.51 percent annually versus 11.27 percent, as measured by key market indexes. The return on "small-cap" value stocks was even higher, at 14.13 percent annually. The generally higher returns from value-oriented stocks and funds is also known as the "value premium."
At all times, value and growth investors must be aware of inflation risk. That means the gradual erosion of purchasing power by the inexorable economic process of inflation: a decline in the value of money. If your investment returns aren't keeping pace with the rate of inflation, you're losing money. This scenario should provide serious food for thought for those who want to build savings, or who have certain future expenses in mind, such as a new home or a college education. The answer may lie in investments that should keep rising in an inflationary environment, such as real estate, natural resources, or gold. To completely avoid stock market declines as well as inflation risk, you might also look into Treasury inflation-protected securities, or TIPS, safe fixed-income bonds that are indexed to the gradual rise in the cost of living.
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