Stocks And The Trinity Of Risk
Avoiding permanent capital loss from your stock market investments is possible. Before you improve your investment strategy, you need to understand the factors that can result in these losses. Here’s the “trinity of risks” associated with buying and holding stocks:
Risk of Valuation
If your stock’s earnings are at a high for the cycle, the existing P/E may hide stock that is overvalued. You can use an adjusted ratio for P/E, which works by replacing current per-share earnings or EPS with an EPS that covers an average of ten years. This method helps smooth out the effects of income volatility. If you’re screening out stocks that can threaten your overall portfolio, look for those that have adjusted ratios lower than 16.
Excess leverage can bring a company to its knees and into bankruptcy, which can be unavoidable even if the business is essentially sound. As an investor, you need to be especially sensitive to monetary risks in a sluggish economic environment where credit is tight. You can steer clear of stocks from these companies by using the Z-score, which was formulated by NYU’s Edward Altman. Screening using this score, avoid businesses that have a score lower than 1.8 – this is a good indicator of a business or company’s risk towards going bankrupt.
If your stock earns much higher today compared to the historical average, this might be due to investors calculating future income from an overstated base, giving the stock valuation it shouldn’t have. This type of risk can be aggravated towards the end of a stock market bubble. Pick stocks form companies that have an EPS that’s double the ten-year average or more.
You can avoid permanent capital loss on your investment portfolio by carefully choosing the stocks you want to purchase and hold. A good rule of thumb to follow to avoid these losses is to evaluate companies, not just by today’s valuations or current factors, but also by merits such as growth potential. Consult with your investment planner as to how you can use the “trinity of risks” and apply it to your stock market investment strategy.
Puritan Financial Group has years of experience in dealing important financial decisions. Puritan Financial Group will listen to you and your loved ones and craft a custom financial solution that supports your life goals.