Although it is a fact that returns on long-term investment in equity shares are always rewarding when it is compared with returns generated by other investing avenues. But at
At the same time, it contains various risks that an investor needs to be aware of before investing in it
- 1 What type of risk is involved with the stock market
- 2 1. Economic Risk/ Market Risk:
- 3 2. Industry-Related Risk:
- 4 3. Company Management Risk:
- 5 4. Inflation Risk:
- 6 5. Interest Rate Risk:
- 7 6. Exchange Rate Risk:
- 8 7. Credit Risk:
- 9 8. Liquidity Risk:
- 10 9. Taxability Risk:
- 11 10. Regulatory Risk:
- 12 11. Black Swan Event Risk:
- 13 1. Learning through Reading:
- 14 2. Diversification –
- 15 3. Long Term Investing-
- 16 4. Hedging:
- 17 5. Acknowledging the Fact that Risks Have to Be Faced:
- 18 Additional Information
What type of risk is involved with the stock market
Some of the risks associated with stock market investing are described below –
1. Economic Risk/ Market Risk:
Economic Risk also known as Market Risk is the possibility of an investor experiencing losses due to factors that affect the overall performance of the economy and hence financial markets.
The performance of any company to a certain extent depends on the growth of the economy. A slowdown in the economy affects almost all the sectors of any company in varying proportions. Such Economy related risks are usually reflected in factors such as GDP growth, inflation, interest rate, etc.
2. Industry-Related Risk:
Industry Risk refers to the possibility of an investor experiencing losses due to changes in the dynamics of a particular industry or sector. Every industry or sector passes through different stages of growth – i.e., startup, expansion, consolidation, maturity, and decline. The returns generated by an investor investing in shares of companies belonging to any specific sector or industry depend on the stage in which that industry or sector is.
Apart from this, there are various sectors that are cyclical in nature. In upcycle companies of such sectors make huge profits while in the down cycle they make losses as well. Hence returns to investors may vary depending on when he/she has entered stocks of such sectors.
3. Company Management Risk:
Company Management Risk refers to the possibility of an investor experiencing losses due to investing money in companies having management-related issues.
The future success of a business is directly tied to the quality of its management. Hence it becomes very important to assess the quality of management before making any investment decision.
Here management related issues include factors related to the quality of management in terms of honesty, integrity, competence, level of corporate governance, treatment towards minority shareholders, etc. 09)
4. Inflation Risk:
Experiencing losses due to an increase in inflation. Inflation Risk refers to the possibility of an investor With an increase in inflation, the price of raw material increase, which affects production cost and reduce the profitability of many companies. At the same time, an increase in inflation reduces the purchasing power of the common man which ultimately causes a slowdown in the economy.
5. Interest Rate Risk:
Interest Rate Risk refers to the possibility of an investor experiencing losses due to changes in interest rates.
Reserve Bank of India (RBI) makes changes in Interest Rates as a part of its Monetary Policy in order to control inflation.
By increasing the interest rates, the RBI basically attempts to shrink the supply of money to discourage spending by making it expensive to borrow money. Conversely, when it
decreases the interest rate, it increases the money supply and encourages spending by making it cheaper to borrow.
Thus rising interest rates can lead to slowdown in various sectors and thereby economy in general. Similarly reducing them can give a boost to several sectors and thereby economy in general.
6. Exchange Rate Risk:
Exchange Rate Risk refers to the possibility of an investor experiencing losses due to currency fluctuations.
Today because of trade globalization, many companies deal across nations and hence fluctuation in exchange rates affects their financial performance.
Apart from this there are many companies who are directly or indirectly involved in import/export activities, for example, import of raw materials, export of finished goods, etc. The financial performance of such companies depends a lot on fluctuations in exchange rates.
Risks Associated With Stock Market Investing, For example, the appreciation of the Indian rupee makes imports cheaper and exports costlier while the depreciation of the Indian rupee makes imports expensive and exports cheaper.
7. Credit Risk:
Credit Risk refers to the possibility of an investor experiencing losses due to a borrower’s failure to repay a loan or meet contractual obligations. A company, borrowing money for business, has to pay interest on it until it repays the borrowed money. However, during the down cycle of any industry or economy in general, companies having a heavy debt burden find it difficult to meet their liabilities and the chances of their becoming bankrupt increase. This leads to massive erosion in the value of their shares.
8. Liquidity Risk:
Liquidity Risk refers to the possibility of an investor experiencing losses due to lack of marketability and liquidity of the investment.
This risk is present in stocks which have high bid-ask spread. This is mainly because of scarcity of supply or demand in the market.
This is common in various stocks which have low equity based and very low free float or in case of stocks which have been ignored by investors for some or other reason.
In such cases investors may suffer loss as they may not get the right price for their stocks or at times they won’t be able to sell them at all.
9. Taxability Risk:
Taxability Risk refers to the possibility of an investor experiencing losses due to changes in tax policies by the government.
Changes in tax policies or tax rates can significantly alter the business prospects of one or more sectors or companies. For example increase or decrease in duty or GST rates on certain products can affect the businesses relating to it; that can be manufacturer or consumer.
Further, there are few industries which are taxed comparatively higher as compared to others and hence, their net profit after tax may be less.
10. Regulatory Risk:
Regulatory Risk refers to the possibility of an investor experiencing losses due to regulatory issues which may be sector specific or at times company specific.
Some of the sectors that are highly regulated include Cigarette and Tobacco, Telecom, Pharmaceuticals, Chemicals, etc.
Any unfavorable change in regulations can significantly alter the business prospects of the entire sector or some of the companies operating in that sector.
11. Black Swan Event Risk:
It refers to the possibility of an investor experiencing losses due to occurrence of a black swan event.
A black swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences.
Some examples of black swan events include large scale natural disasters like floods, draughts, hurricanes, terrorist attacks, wars, etc.
The latest example of a black swan event which has affected global economies and their stock markets is the spread of Corona Virus (COVID-19) in 2019-20. Such events can at times have disastrous consequences.
Dealing with Risks associated with Stock Market Investing –
Benjamin Graham, Father of Value Investing, famously quotes –
“Successful Investing is about managing risk, not avoiding it.”
Below we have mentioned some ways in which you can manage risks associated with stock market investing.
1. Learning through Reading:
Warren Buffet often quotes –
“Risk comes from not knowing what you’re doing.”
Some of the risks associated with stock market investing can be reduced to a great extent just by learning.
Legendary investor, Warren Buffet credits many of his great investment decisions to his reading habit. He still spends as much as 80% of his day reading.
It is advisable for new comer to, first try to understand the basics about the stock market, fundamental analysis, technical analysis, etc. by reading investing books. Investors should also try to gain understanding about the economy in general and working of various sectors.
Apart from this investors should spend time reading to learn about companies in which they have invested money or wish to invest. It would be best to read the annual reports of such companies.
Remember, if you are able to understand the basic concept behind the risks involved in stocks, you can control the amount of risk you can or want to take.
2. Diversification –
Some of the above mentioned risks can be reduced by a great extent by maintaining a well diversified portfolio of stocks from various sectors of the economy.
The concept of diversification can be best understood by the age old saying,
“Don’t put all your eggs in one basket.”
By maintaining a well diversified portfolio of stocks from various sectors of the economy the weightage of any particular company or a sector in your portfolio gets reduced and hence the impact of risk factors affecting any specific company or sector on your entire portfolio reduces.
3. Long Term Investing-
your Some of the risks associated with stock market investing can cause huge volatility in short term by effect of such risks can be greatly reduced by increasing investment horizon. Always remember, a short-term fluctuation won’t hurt well diversified portfolio in the long run as most of the short-term market risks get nullified while investing for duration of 10 to 15 years.
Legendary investors like Benjamin Graham and Warren Buffet always insist on investing for long-term to create a healthy wealth.
Below are some of their famous valuable quotes that an investor must consider before investing –
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” ~ Benjamin Graham
Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.” ~Warren Buffett
Hedging is a risk management strategy which can be used to limit or offset probability of oss due to fluctuations in the prices of stocks.
against major downside by hedging it buying index put Seasoned market players often protect their portfolios options.
5. Acknowledging the Fact that Risks Have to Be Faced:
It may sound strange, but one of the ways of dealing with risks associated with stock market investing is acknowledging the fact that there are some risks that are to
Some of these risks like market risk, interest rate risk, inflation risk, regulatory risk, taxability risk or even black swan event risk, etc are beyond anyone’s control. Such risks are known as systematic risks. These risks have to be faced.
There is a famous quote,
“The biggest risk is not taking any risk.”
Acknowledge the fact that people who take calculated risks are generally rewarded by stock markets in long term.
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