I remember someone saying to me years ago that the stock market creates and takes away fortunes every day. This is true and so I need to be careful to ensure that I don’t lose excessive amounts of money. Yet if I’m careful about my risk management and stick to good strategies, here’s how I can make the market work on my terms.
The strategy
To begin with, it’s key to understand what my terms are. My focus right now is on generating a second income, to take the pressure off my main job. So straight away I can discount some stocks that simply don’t fit the bill. In doing so, I can reduce my risk straight away by not getting involved in unneeded distractions.
My focus is on two segments. One is dividend stocks and the other is growth stocks. I’m going to aim to make both generate cash for me in coming years, but in different ways.
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For dividend stocks, I’m aiming to buy and hold for the long term. On a quarterly or semi-annual basis, the company should pay me a dividend. I can either take this and enjoy it straight away, or reinvest it to buy more of the same stock. Then in the future my income payments should be larger.
With growth stocks, I’m still buying with the aim of holding for a long time, but I’m prepared to sell in order to turn profit into cash. For example, if I invest £1,000 that grows to be worth £3,000, I’d be happy to sell £1,000 worth of the stock to bank this as income, and leave the other £2,000 to hopefully keep growing.
The risks
I don’t want to get overconfident, as any investment has risk. For both dividend and growth shares, one big risk is if the share price falls. In some cases, it could be months or even years before it recovers. This could prevent me from being able to trim any profits from growth stocks.
Having a diversified portfolio helps to reduce this risk. Further, by owning dividend stocks, I can still aim to bank income during this period. Even if the share price is below where I bought it, I can still enjoy the cash. A smart play here is to use the dividend to buy the stock at the lower price, thus giving me a lower average buying price overall.
Another risk is that I don’t have enough cash to invest to make a meaningful difference. The strategy should work fine, but if I can only afford to invest less than £100 a month, it’s going to take a long time before the second income will add up.
The rewards
If I invest in a portfolio that generates me an average yield of 7% and I invest £500 a month, the rewards can be large.
After just five years, the income in the sixth year should amount to just over £2,800. If I kept reinvesting for a decade, I could make £6,525 in year 11.
