Investing in stocks provides notable advantages compared to other investment options or vehicles. Historical data from developed and developed countries demonstrate that stocks tend to outperform both the money market and bonds. However, like all other investments, it has notable risks. Some of these risks are inherent in stocks.
Types of Risks to Know as a Stock Market Investor
Every investor should know that investing in stocks can lead to either profitability or losses. When you invest in stocks or the stock market, there is a possibility for you to accumulate wealth. It is also possible for you to lose money.
It is important to highlight the fact that stocks are inherently riskier than bonds, as well as the money market. Of course, with higher risks come possible higher returns. Stocks are generally ideal for investors with aggressive risk profiles.
Nevertheless, for beginners, as well as those looking to expand further their investment portfolios, it is important to understand the risks or types of risks in stocks and decide whether these risks are tolerable. Take note of the following:
1. Market Risk
There are two types of market risk in stocks: systematic risk, which comes from the day-to-day fluctuations of stock prices in the market, and unsystematic risk, which arises from circumstances affecting a particular company or an entire industry or sector.
Avoiding systematic risk requires either continuous monitoring of stock prices or reducing the trading frequency and avoiding haphazard reactions to sudden but short-lived market downturns through technical analyses.
On the other hand, unsystematic risk can be avoided through active monitoring of news and all other relevant events related to involved companies and industries or sectors, as well as performing regular fundamental analyses.
2. Business Cycle Risk
Most companies undergo specific cycles of profitability and unprofitability due to the seasonal nature of their businesses. Some companies also perform poorly during specific phases of the economic business cycle. These issues are collectively referred to as business cycle risk.
Some investors react negatively to seasonal business downturns or when a particular industry or the greater economy is not doing well due to the natural business cycle. They tend to forego stocks that experience price drops.
However, because there are companies that go through a cycle of productivity and unproductivity, investors who sell stocks during business downturns can also miss the possible gains that come whenever a business or the entire market recovers.
3. Management Risk
Another important type of risk in stocks is the so-called management risk. This is somewhat similar to unsystematic risk but it focuses more on the leadership direction of executives, senior managers, or other key decision-makers of involved companies.
The capabilities of decision-makers can make or break a particular company. Instances like mismanagement, poor financial decisions, and organizational change, among others, can affect the productivity and profitability of a particular company.
Management risk essentially tells that investors can lose the value of the stocks they own due to poor leadership. This is beyond their control but it is avoidable through regular monitoring and reviewing of events and developments transpiring in involved companies.
4. Liquidity Risk
One of the advantages of investing in stocks is that it is more liquid than other investment options such as bonds, real estate, and futures or contracts, among others. However, it is less liquid when compared with cash deposits and other money market instruments.
Liquidating stocks and turning them into cash is relatively easy through a sell order via an online trading and brokerage platform or with the assistance of a broker or portfolio manager. However, in some instances, some stocks are unappealing to buyers.
Even issuing companies might be unwilling to buy back issued stocks due to financial woes or internal constraints. Some stocks become unappealing when involved companies have garnered negative perceptions due to their poor performance.
5. Interest Rate Risk
The stock market responds to interest rates set by a central bank and followed by commercial banks. For example, in the United States, whenever the Federal Reserve cut interest rates, the stock market tends to go up, thus leading to capital appreciation.
However, whenever a central bank increases the interest rates, stocks have the possibility to go down, thus leading to depreciation. The reason for this is that interest rates affect the financing capabilities of companies, specifically the cost of borrowing.
A buy-and-hold strategy is the default response to interest rate hikes. However, interest rate risks are inevitable and can affect active investors and traders. An investor should ensure that he or she has a diversified investment portfolio that does not depend alone on stocks.
6. Inflationary Risk
The stock market also responds to the inflation rate. Note that a central bank addresses prolonged high inflation rates by raising interest rates as part of its monetary policy. Remember that stocks tend to go down when interest rates are high.
Prolonged periods of high inflation rates weaken the purchasing power of consumers. This affects the profitability of companies. In addition, inflation also affects production inputs, thus increasing the cost of doing business and reducing profitability.
A combination of high interest rates and high inflation results can also result in stagflation and weaken the economy, thus increasing the possibility of a recession. A recession marks an overall decrease in business earnings and productivity.
5. Regulatory Risk
Changes in policies or the relevant regulatory environment can affect certain companies or the industries or sectors in which they operate. Newer laws or regulations and standards can affect the existing trajectory of a particular business.
A particular government and even a supranational governmental organization can impose new rules or even penalties that can affect the financial standing of a multinational company. The imposition of new taxes can also affect business earnings.
Investors seeking to lessen their exposure to regulatory risk should focus on investing in stocks or more specifically, in companies in particular industries or sectors that are either resilient to changes in the regulatory environment or have stable environments.
