Investing in the stock market provides great returns, but it also entails risks, or the possibility that you will lose some or all of your investment.
The higher the risk, the higher the return. If you have low tolerance for risk, then you must settle for a low return.
Financial Risk
The financial risk in the stock market is when you bought shares of a company but their prices dropped due to any fundamental reason. This can happen even when the economy is doing well.
You can minimize this risk by researching in advance, choosing your stocks carefully and using common sense.
Buying shares of a company without a proven track record of solid profits and sales, among others, is speculating — not investing. Companies with high debt, low or no earnings and face stiff competition pose high financial risk.
Inflation Risk
Inflation is the increase in the prices of goods and services. Inflation risk, also called purchasing power risk, happens when your money can no longer buy as much as it used to. For example, you were able to buy a pair of shoes for one dollar way back in the 1950s, but the same dollar can no longer do that now.
You face risk when your investment fails to keep up with inflation. If you kept your money in a bank that offers a 1% interest, but inflation is at 3%, then you are losing money.
Interest Rate Risk
Investors keep an eye on interest rates because they change regularly.
The US Federal Reserve, or the Fed, raises and lowers interest rates, which banks follow.
For example, you bought a long-term corporate bond with a 5% yield. But after that, interest rates went up to 8%. You then lose the chance to earn that additional 3%. If you sell the 5% bond before maturity date, no one will buy it because the market is offering 8%.
Tax Risk
Taxes, like income tax and capital gains tax, do not affect your investments directly but they reduce the amount of money you can keep.
If you make wrong decisions, such as selling your stocks at the wrong time, you may pay higher taxes than necessary. Tax laws are considered by investors because they often change.
Market Risk
This involves supply and demand, causing stock prices to rise and fall depending on sentiments of millions of people buying and selling shares.
It is not advisable to buy stocks if you are planning to hold it for only a short time such as a year or less, as it is difficult to predict a stock’s movement in the future. Markets are volatile and investments would need time for them to grow, no matter how fundamentally sound a stock may be.
Political Risk
Politics and government policies can affect a company’s operations. While a new law may boost profits, others may cause firms to go bankrupt.
If you happened to put your money in companies or sectors that are exposed to political risk, you may think about selling them or placing stop loss orders on the stock.
Emotional Risk
Emotions are the key drivers of investors’ decisions, especially greed, fear and love. A good investor does not allow emotions to cloud his/her money decisions, which could result in loss.
Greed causes an investor to forget common sense and ignore fundamentals. This happens when you choose to put your money in a dubious stock for a quick buck. In contrast, fear of loss causes a person to avoid good investments and settle for low returns.
Investors may also fall in love with a stock, refusing to sell it even after its price has plunged and is showing signs that the situation will get worse. For example, you bought AAPL stock at $114 and you see it tumbling before your eyes but you keep holding and praying that one day it will come back to your buy price. There is also emotional risk when you make bad investment decisions just because they sound good or because you are persuaded by family and friends.
Personal Risk
While most risks are not directly related to you, some are caused by an investor’s personal circumstances.
This scenario often affects investors who have not prepared an emergency fund to cover unexpected expenses, such as a sudden layoff, natural disasters, accidents and other emergencies. Make sure to set aside a rainy day fund before entering the stock market so you will not be forced to abruptly sell your stocks to pay for emergencies. You can put your emergency cash fund in a bank savings account or a money market fund.
After reading all these risks, you might wonder if entering the stock market is still worth it. But don’t worry, because you can minimize risks by equipping yourself with knowledge. Ignorance is the greatest risk in investing, so educate yourself in terms of how the market works and the factors that influence a stock price, among others.
If you still do not understand the market, stay out of it in the meantime. Give yourself time to learn. At the same time, make sure that you are financially secure before braving the trading floor.
Keep at least three to six months’ worth of your living expenses in case you encounter emergencies. Pay off your debts and secure your job and insurance.
Another strategy to reduce risk is through diversification, or distributing your money across different investments. Do not put all your cash in just one stock, one industry, or one investment type. Complement your portfolio with bonds, treasury securities, bank accounts, precious metals and real estate.
While investing in the stock market can help you grow your wealth over the long term, you should make sure to understand potential risks before you shell out money. The common risks investors face are financial, interest rates, taxes, market, government, emotional and personal.
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