One of the main advantages of investing in common stock is that it gives greater return in long term than those received from most other investments. However, the biggest fears of market participants in the stock market is chances of losing some or all of the invested amount. As an investor you can lose some of your investment capital if prices of the stocks fall below your buying price. This chances of losing money is known as risk.
Risk is the uncertainty related to the outcome of the stock market investing.
Market participants are more nervous about investing in stocks than other investment options. Experts suggest not to fear risk as it’s part of investing in the stock market.
Before investing, you better understand the investment, their risk and return, and work on your own investing style to avoid or minimize stock market risk.
Return from the stock market comes in the form of dividends and capital gain. An investment plan can guide you to achieve your desired objective by minimizing risk and maximizing your return.
Why stock price falls
Stock price gets affected based on the expected earnings of the company. When investors expect decline in a company’s future earnings, shareholders sell their stock, due to which there will be downward pressure on the stock’s price.
Similarly, the reverse is also true. When investors expect higher returns from the company, they buy stocks. They are willing to pay higher prices for the stock in anticipation of higher profit. Due to this reason, you will see certain stocks trading at a higher P/E ratio.
Certain stocks in the market also fluctuate based on how the economy works.
What does it mean? It means, stock prices go up and down based on how investors react due to the risk associated with the market.
In this article, we will tell you different types of risks stock investors should know while investing in the market.
Major type of risk associated to stock market are;
- Business Risk
- Financial risk
- Interest rate risk
- Market risk
- Inflationary risk
- Political and government risk
Every business has its own risk. When it comes to the stock market, you need to first assess the uncertainty that relates to the company’s sales and earnings.
Some companies’ businesses are such that its sales and earnings are more uncertain than others.
If sales and earnings comes down significantly due to certain uncertainty, then the company may not be in a position to cover its interest costs, principal and dividend. Due to which demand of the company’s stock will come down and there will be downward pressure on stock price. You have to be very careful as the company may go out of business, which will make its stock worthless.
The best way to manage business risk is through diversification and picking strong fundamental stocks.
When you invest in a stock, the most important criteria to consider is the financial health of the company.
You can know how the company is funded by analyzing its balance sheet.
If the company has more debt on its balance sheet compared to the equity capital, then there are chances that it will face bankruptcy in case of any trouble in inflows of cash.
This type of risk is referred to as financial risk. It refers to the risk associated to the company because of the debt it has in relation to its equity. You can find it out by calculating debt to equity ratio.
You can avoid these types of companies with the help of fundamental analysis tools.
If a company has a greater amount of debt in comparison to equity, then the financial risk is higher as it needs to generate enough earnings to first pay its fixed interest and principal before paying anything to shareholders.
Failure in payment of debt interest and principal, can lead to bankruptcy. In case of bankruptcy, the value of the stock can be worthless.
Therefore, companies with little or no debt are financially risk free stocks.
Some companies are bound to take debt depending on the nature of business.
For instance, infrastructure companies are required to take more debt as they have to invest in capital assets in order to get money. However, based on your risk appetite you need to choose the stock.
When you invest in companies that did not have a proven track record, it means you are not investing, you are speculating.
If the company is making enough profit to compensate its debt repayment, then you need not worry about the debt. However, in case of economic turbulence, you need to make sure that the inflow will be sufficient for the company to repay debts.
You can avoid financially risky stock by investing in companies with low debt-to-equity ratios or in debt free companies. Don’t forget to take other fundamentals into account before investing.
Impact of Interest rate
Interest rate is the cost you pay for using borrowed money in your business.
Change in interest rate affects consumer, businesses and investors.
When the central bank raises or lowers interest rates, in turn, banks have to raise or lower interest rates.
When the interest rate rises, the cost of borrowing money also rises. Therefore those companies that carry a large amount of debt in it’s balance sheet, ultimately have to pay more towards interest for using borrowed funds.
In case companies profit drops substantially, it will become very difficult to repay debt. Due to which, demand for the stocks comes down, and stock price falls.
Rise in interest rate also affects consumers and customers of the business due to which their buying power is reduced affecting those companies whose sales are depended on these people. In other words, the financial health of a company’s customers directly impacts the ability to grow sales.
For example, if interest on car loans increases, then customers don’t take loans to buy cars or postpone their buying, which has an impact on car manufacturers.
Similarly, if interest rate increases, then home buyers don’t take loans from banks or postpone their buying to a future date, affecting the real-estate and banking sector.
Although rising interest rates hurts these industries, the reverse is also generally true. Therefore, you need to change your strategy according to the movement of interest rates.
Stock market goes up and down based on millions of individuals’ daily buying and selling decisions on stocks. Every trading day affects the share price of the stock.
When demand for a stock rises, its price rises. Stock price rises further if the supply is limited and demand is picking up.
Conversely, if no one or few people are taking interest, it means the stock has very less demand, its price falls.
Ups and downs of the market depends on the supply and demand of the stock. Supply and demand defines the market risk.
Remember, market risk can not be diversified as it is related to movement of stock prices in general. This risk is not related to the fundamentals of any company or industry.
Inflation risk is also known as purchasing power risk.
In case of high inflation, consumers pay too much money in exchange of goods and services. It reduced their purchasing power as they will be left out with less money.
Which means, if prices in the economy keep rising, then the purchasing power of the investor gets reduced. In other words, future value of your money will purchase less in goods and/or services than they would today.
You can manage inflation risk by investing in higher return investments such as stocks for a long period of time.
Impact of government decisions
Political and government risk refers to the uncertainty that can affect the market and your investment due to changes in the political environment. Before investing, you need to check the impact of political and government risk on your stock.
If the industry in which the company operates is exposed to political and government risk, a single new regulation can send the company into bankruptcy.
Conversely, a law that is in favour of the industry, can help the company to make a good amount of profit.
Other risk that impacts your stock market investment is emotional risk. It’s not associated with the stock market, but is very much with you and all other market participants. We have three main emotional risks: greed, fear and love. While making a buying and selling decision, you have to understand these emotional risks and their impact on your decision.
Do you think you can completely avoid stock market risks?
No, you can’t. Risk even cannot be avoided with the most conservative investments. Risk is a natural part of investing.
As an investor you need to find your comfort level with risk and construct an investment strategy around that level to maximize your return in the stock market. You can try a mixture of different assets along with stocks to control some of the risks.