Understanding Stock Market Risk Tolerance: Big Ships vs. Small Ships

By | August 14, 2007

My cousin wanted to invest some money in the stock market. He had previously opened a brokerage account and traded highly volatile penny stocks and lost most of his investments. It wasn’t a lot of money but it put a huge dent in his confidence and forced him to close his account and withdraw from the stock market.

The main reason for his loss in the stock market was because he concentrated only in penny stocks. He was one of those people that eyes the largest percentage gainers and hopes to get in and ride the stock to enormous gains. In reality, he always bought the pennies stocks at the high and sold them after the stocks has gone south.

He reasoned that the only way to make money was through penny stocks, because they can run up very quickly. I quickly added to his statement that penny stocks can run down very quickly as well. There is tremendous risk playing with penny stocks, especially with over the counter stocks.

After a period of avoiding the stock market, he wanted to get back in. So he asked me what to invest in. I replied that I would need to know more about him as an investor. Generally I start with these three questions to get an idea of the person:
1. What is your investment time horizon?
2. What is your risk tolerance?
3. What is the size of your investment?

The investment time horizon is the length of the period of time you are planning to hold your investments. There is obviously a difference between investing for a house you will buy in two years as opposed to investing for retirement thirty years down the lane. The risk tolerance is to determine how much risk you can stomach. Basically, how much money can you lose without losing sleep? The size of your investment will determine how diversify you can be. Generally, the larger the investment, the more diversification you should take.

My cousin said that his goal is to buy a condo in five years. He has saved up about 20K, and since this money will go towards his down payment, he cannot afford to take much risk. So this gives me a very good idea of which investment path he should take.

Five years is a long way to go and if he invests his money wisely, he could use this period of time to help himself towards achieving the goal.

But first, I have to explain to him about risk tolerance. It is very important to understand the level of risk you can take. I came up with an analogy to talk about the stocks and the stock market. I told him to think of the stock market as the ocean and stock companies as ships. Imagine you’re sailing in the middle of the ocean. Would you want to sail on a big ship or a small one? A big ship in the ocean is like a blue chip in the stock market, and a small ship is like a small company. The big ship is more stable; it generally moves slower but is less responsive to big waves. The small ship, on the other hand, can move a lot faster but can be swallowed by a big wave. Which size ship would you be more comfortable riding? How much excitement do you want? That all depends on the individual investor.

Just like the ships at sea, the companies in the market are susceptible to market waves.
Small companies, like small ships, carry a high risk in the stock market and are more volatile. While investing in small company stocks, or small caps, can double your money, a single bad news can tank the stock. Big companies, like big ships, do not move as fast in the stock market but they are generally less responsive to the daily market fluctuations.

I would advise new investors to start with big company stocks, or large caps. I suggested to my cousin to put his money in large caps if he doesn’t have the time to do his own research. Large caps are less volatile and carry lower risk, which are good points, because he would use this money as a down payment. If my cousin has extra money that he can afford to risk, then he can use the extras to buy small caps. With most or all of his money in large caps, he does not have to lose sleep over his investments. Another point is, you have to be comfortable with your investments so that you can sleep at night. If you’re constantly worrying about a stock’s performance, then you should either reduce your holdings or don’t invest in them at all.

The key is to find your own comfort zone. Once you know your comfort zone then you are on your way to investing. If you are not sure about how much risk you can stomach, start with safer investments, like large caps and move slowly towards higher risk stocks. Even if you can stomach huge risk, it is always good to diversify risk. Have at least one foot on the big ship, so even if there is a huge wave coming, you’ll know that at least one foot will be safe.

10 thoughts on “Understanding Stock Market Risk Tolerance: Big Ships vs. Small Ships

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  3. Jason

    Good advice, clearly stated. I found you through Carnival of Personal Finance #114, and I am going to mention your article on my blog http//finance.jasoncrews.name.

    Thanks for the article.

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  5. Aaron

    All investors need to be aware of the risks involved with whatever stocks they are investing in before they invest in them. When investors don’t understand the risk, they end up panic selling at the lows and lose money. Good article.

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  8. Brandon Carter

    it is good to invest in the stock market but you must be very careful and not speculate on rising stocks.:’~


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