Risk Approach In Selecting Stocks

Many people buy stocks due to positive reasons. For instance, the market is booming, friends buy and make money, experts advise strong buys, your special liking for certain companies, and so on. These are the situations where you should hold back and think some more. I would advise that you use what you hear as a starting point, to be followed by doing some research on your own. You should make a final judgment as to which stocks offer the lowest risk. Why do I emphasize risk rather than profit? It will help you gain an objective view to weed out the weak companies.

Since there exist thousands of companies being traded, the logical place to begin is to determine your own price range to fit your budget. Then you start the process of elimination to arrive at a shortlist of stocks you want to buy. Your shortlist may range between one to fifteen companies to give you both focus and choice. It also represents the different industries you are interested in.

To buy a stock, you need some understanding of the nature of the company’s business in order to assess the risks. High-risk business always involves intense competition and ease of entry resulting in slim profit margins. Examples are: restaurant, travel, entertainment, airline, and retail in general. These kinds of business are the first to suffer from a downturn, and usually the last to recover. Exceptions are companies that have developed a niche, a strong brand name, or a chain-store operation to compensate for the risks involved, such as McDonalds’s, Disney’s, Starbucks, and Wal-Mart.

High-tech companies are both high risk and high growth due to fast technological change in hardware. The software part is basically a competition of new ideas for the development of killer applications to replace existing ones or to generate a whole new market. The high-tech industry is characterized by “creative destruction”. Big companies are not immune from intense competition if they fail to innovate fast enough to stay ahead. Recent examples of big companies in distress are Hewlett Packard and Yahoo! The high-tech industry also has the power to destroy traditional industries by making their operations obsolete, for example, typewriters, photographic films, letter mailing, paper publishing, landline phones, and anything that can be digitalized.

The banking industry looks pretty safe except for the financial meltdown of 2008 where many big banks lost more than 90% of their stock values such as Citibank and Bank of America. The carnage was self-inflicted because of the real estate bubble they helped create. Even for a safe industry like banking, recklessness on the part of high-level executives can ruin your stock investments.

Despite volatile fluctuations due to speculation, the energy industry appears least risky of all because existing sources such as oil, gas and coal are non-renewable and in limited supply. As a result, energy stocks move up and down within a relatively narrow range. The increase in energy demand can only go up in the long run due to population and economic growth. This industry is dominated by big companies whose operations have already achieved full vertical integration ranging from exploration to retail. Small oil companies without vertical integration only survive on slim profits. In the long term, fossil fuels will be subject to increasing pressure from the emerging renewable clean energy. The danger does not appear urgent until cost parity is achieved by renewable energy, especially solar. When that time comes, very likely within this decade, the world will see a mass exodus from fossil fuels to clean energy sources.

What about emerging industries? Emerging industries means new demands created by new technologies. Despite being hyped, they carry a lot of uncertainties as to their future prospects. Examples are: new medical drugs, biotech, nanotech, etc. These industries require regular infusion of capital to sustain their research efforts. They will die for lack of investment funds before the research comes to fruition.

Another type of emerging industry is worthy of special mention. The Internet has proved to be a phenomenal emerging industry, giving rise to other big ones such as searching and social networking. They seem to have created huge markets out of nowhere. However, if you look deeper, those markets have always existed. They originate from human instincts: curious about our surroundings, and the desire to find out and to communicate with others. The Internet has successfully brought out these latent demands.

Besides looking at the risk factors of different industries, you also need to have some historical perspectives about the stocks you want to buy. What are the high points and low points over the last few years? Why do you think they went up or down? If you buy at a low point now, what do you think will boost up the stock? On the other hand, if you buy at a high point now, how high do you think it can go?

(April 2012)

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One Response to Risk Approach In Selecting Stocks

  1. Does any person know of any forums that discuss this issue in extra detail? I am mesmerized.

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