Investor Toolkit: How to manage risk when investing in the stock market

Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a new or experienced investor, these weekly updates are designed to give you specific advice on the fundamentals of successfully investing in the stock market. Each Investor Toolkit update gives you a fundamental tip and shows you how you can put it into practice right away.

Today’s tip: “It pays to stay aware of market risk, but don’t let it become an obsession.”

As we saw in the past few years, stock prices do sometimes reach a market peak or “top,” then go into a deep slump that lasts a year or two, or even longer. However, some investors and advisors make a career out of analyzing past market tops and the declines that followed. These “top-stalkers” always seem to think the next such decline is just around the corner. Here are three common top-stalker categories:

• Permabears. Many of these investors failed to buy when stocks hit a low in 2009, or earlier great buying opportunities, such as in 2002, 1998, 1992 — or even 1987. They bitterly resent this lost opportunity for investing in the stock market, and they let it colour their outlook on the future. To permabears, stock prices always seem “too high.” They let their wish for a second chance to buy cheap turn into a prediction of an imminent, once-in-a-generation market crash that may come decades in the future, if ever.

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• Commercial alarmists. Pessimism and dire predictions are the stock-in-trade of some newsletter publishers. They cater to investors who share their views. Some have regularly predicted financial calamity for 20 years or more. Some tie their grim predictions in with predictions of terrorism and social breakdown, the spread of new viruses, such as H1N1, and lately, tight oil supplies caused by restrictions on offshore drilling. Their forecasts are the investment counterpart of Elvis sightings.
• Lucky-lines/magic-numbers specialists. These investors and advisors practice an extreme, near-mystical form of technical analysis (market analysis that focuses on stock-price changes and trading data rather than company fundamentals). Instead of an aid to profitable investing, they are looking for what you might call “a sign from heaven” that we about to enter the “7 bad years.”

Our advice: Be a cautious optimist. Don’t let top-stalkers or other market pessimists keep you from investing in the stock market. Instead, control risk by following our three-part strategy: Invest mainly in well-established, dividend-paying companies; spread your money across most, if not all, of the five main economic sectors (Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities); and avoid stocks in the broker/public-relations limelight.

If you buy gradually during the course of your working years (this is known as “dollar-cost averaging”), market declines will have little effect on your long-term profits. Next Wednesday, July 28, 2010, Investor Toolkit will demonstrate how to use this technique to maximum advantage.

If you have investment-related questions, or if you’d like to ask me about stocks you’re considering buying (or selling), you should join my Inner Circle service. Click here to learn more.