What Are the Risks of Investing in Stocks?
Have you ever been burned when you bought a stock? You buy it and shortly thereafter, it tanks. It almost seems like they were waiting for you to buy before they started dumping the stock.
I know because I have been in that situation before. Luckily, I have learned how to manage the situation so it's not so severe. I still lose some on occasion, but not nearly as much. And, my gains are greater than my losses, usually.
It's all about learning and managing about risk. Once I did that, I improved my investing dramatically. You can do the same. You just need to grasp the concept of risk.
We have an intuitive sense about risk. If you get burnt with fire, you know not to touch that again. If you get scammed, you try to be cautious the next time someone pitches to you.
For some reason, when it comes to the stock market, our intuition about it goes right out the window. Our lizard brains allow us to get caught up in the hype!
What Is Risk?
Most people understand risk from a conceptual standpoint. It is something we try to avoid as it may cause pain or harm. Investopedia describes the concept well:
In the context of a the stock market, risk is the danger of losing money with your invested dollars. For most people, they cannot grasp risk when it comes to investing in the stock market. It's an odd phenomenon, but a real one, just the same.
The financial spin doctors make us feel as though we'll miss out if we don't get in on the investments they recommend. By the time it gets to the spin cycle, though, it's usually too late for the investment. You'll get in at the tail end when the stock price is ready to drop.
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Is Risk Manageable for Investors?
A big question you should be asking is why are you watching the financial spin doctors and following their advice? Their motivation is selling advertising space. If you think they exist to help you make money, I have some swampland in Florida that I'll sell to you on the cheap.
The point is, if you had a plan for your investments, the spin doctors wouldn't even be a consideration. You'd be managing the risk of your investments on your terms. The nonsense from the business news becomes nothing but noise, which you can ignore.
The Foundations of Risks with Investing
The foundations of risk are about trying to keep your money safe while staying ahead of inflation. We'll need some measure of what safety means in the investing world. Overall, government treasury bills are considered the safest of investments.
A government treasury bill (short-term) is a safe investment, all equal. Sometimes, it can be treasury bonds, too. Because the government can raise taxes when it needs money, it can back the bills or bonds that it issues. The rate of return on this instrument is known as the risk-free rate for this reason.
Here is the million dollar question though - if the risk-free rate is 5% (hypothetical), how much higher a return should you demand from your stock investments? In other words, why would you pay for a stock that returned on or close to 5% when you can simply put your money into the risk-free instrument?
This is a fundamental aspect of risk regarding the stock market. The closer the returns on stocks come to the risk-free rate, the more investors will head for safety. Why invest in risky stocks when you can keep your money safe by investing in Treasuries?
You've Just Learned About the Equity Risk Premium
The equity risk premium is the amount of excess return (from the risk-free rate) investors require from stocks to justify the risk of investing in them. There is no set amount that works for every investor.
You do have to be realistic about a risk premium you'll feel comfortable with, though. If you set it too high, you'll have fewer companies that will reach your levels.
In general, history can serve as a guide. If you track the historical returns of the market itself and compare that against the companies you own, you'll get a ballpark estimate of the risk premium for that stock.
You could also use measures such as the standard deviations of returns to measure the variability of those returns. A stock that is risky will be more volatile than ones that aren't, all equal.
This equation (standard deviation) is available in spreadsheet programs. Simply download the stock prices, calculate the returns, then take the standard deviation. On its own, the number won't tell you much. You'll need to compare it with the market returns and other stocks in your portfolio.
Five Types of Financial Risk
As if this concept were not complicated enough, there are five types of financial risks to contend with when investing. These are default risk, currency risk, inflation risk, opportunity cost risk, and diversification risk. Here is an explanation of each:
- Default risk - will the investment have enough cash to pay investors back? If they don't they can default on the investments, leaving the investors with little value for the investment. In the case of Enron, the shares were worthless after liquidation.
- Currency risk - when you invest in foreign stocks, currency fluctuations will affect your investments. This is an ongoing risk that must be managed.
- Inflation risk - a dollar today is worth more than a dollar sometime in the future. This is due to the risk of inflation.
- Opportunity cost risk - this one is more subtle. Investments A and B both cost the same amount to purchase. Suppose you choose investment A. After a few years, you discover that investment B is earning a higher return. During this holding period, the opportunity cost for you is the difference between the returns. You chose the investment with the smaller return, thus tying up the cash and foregoing the opportunity to participate in the higher return investment (B).
- Diversification risk - market gurus will advise to never put all your eggs in one basket. That's good advice. Diversification can be a good way to spread your risk. But, too much diversification can dilute your overall portfolio. Therefore, you have to manage your expectations with this type of risk.
It's interesting to note that concerning the risk-free rate, it is only risk-free in terms of default risk. The other risks can affect the risk-free instruments.
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Examples of High Risk Investments
It could take volumes of information to describe all the scenarios that make up examples of high risk investments. However, you'll find a few common themes to help you identify them.
Companies that start paying a high yield on its dividend is a red flag. Most companies that start paying dividends will start at a low rate and work up. This strategy gives them wiggle room, if you will.
What constitutes a high rate? For starters, look at what rate other companies in the same industry are paying out. If the rate you'll get with a stock is much higher, it's time for the warning lights to go on.
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Earnings is another measure that can seem too good to be true. When an established company has an earnings history and then has an unusually high earnings release, you'll want to begin the investigation. Hopefully, they can justify this increase in their earnings call.
Note, it can be legitimate for companies to have unusually high earnings. However, it is something to look into to make sure there is a valid reason.
In general, if anything sounds too good to be true, it likely is. Take Enron, for instance. This was a darling stock on Wall Street. Then, the company got clever with investment schemes and offshore accounts. Overall, you'll want to keep an eye out for significant changes or items that are out-of-the-ordinary.
Don't Forget to Consider Industry Risk
I didn't include industry risk in the list of risks because it fits within the diversification risk category. If you invest in too many companies in one industry, you are subjecting your portfolio to more risk.
Certain industries are risky by the nature the business. Oil companies and tobacco companies are under constant scrutiny by watch groups and government agencies. This puts the risk for these industries at higher levels.
It can still be okay to invest in some stocks within a riskier industry, but understanding that the risk is industry-wide is crucial.
How This Is Useful
On a high-level, discussions about risk make a lot of sense. Putting it into use, however, is more of a challenge. Too many investors look at potential gains without ever considering that loss is a real possibility. This is why it is crucial to evaluate risk in terms of the parameters discussed in this article.
You'll need to make sure these risk parameters fit within your comfort level. If you are risk adverse, for example, you should probably stick to index fund investing. Once you determine your sensitivity towards risk, you can structure a plan for your portfolio. Each investment chosen should be measured against your sensitivity and if it is outside your comfort level, you pass on the investment.
It Takes Discipline
No one likes to miss out on great deals. However, when the deal is misrepresented or is past its prime, you'll forever be chasing these stocks whenever new information is released. Have you ever noticed these business channels don't display the long-term returns of the investments they tout? Why do you suppose that is?
The best advice is to not watch these financial television shows and stop getting hung up on the day-to-day activity of the market. Once you decouple yourself from this habit, you'll find that you won't overreact and your portfolio will thank you for it.
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You Still Need to Monitor Your Portfolio
You should check your portfolio from time-to-time. Situations change, including the economics of companies. Solid companies won't be a problem and you should hang onto them.
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You'll have some companies that start to finagle their books or play other games with the business. They do this for their own financial gain or to appease shareholders. Whatever the case, when you start to notice the shenanigans, it may be time to move on from that investment. You can at least choose to take some profits.
Investment Risk Management Is Complicated
Investment risk management is a simple concept to define, but a difficult one for people to grasp. To learn what is risk in finance is to understand these complications. There are also different types of risk management to add to this mix, which we won't discuss here.
This article only lightly touched upon the highlights of the concept. Companies invest millions of dollars on risk management departments. Therefore, use this article as a starting point and not as a complete guide to risk.
If all this makes you wonder why you should invest in stocks, know that you can be successful when you implement proper risk management and money management. It takes practice to master, but when you do, your returns will improve.