7 Types of Risk Involved in Stocks that You Should Know
7 Types of Risk Involved in Stocks that You Should Know:
“Successful Investing is about managing risk, not avoiding it.”
-Benjamin Graham, Father of Value Investing
Let me be very honest with you. Investing in the stock market is risky. If you think that investing in stocks is as safe as cash or bank deposit, then you are completely wrong.
Although historically speaking, stock market investment has given the best returns compared to gold, bond, funds or other options. However, the return from the market is not guaranteed and you may even lose your entire money in stocks.
Now, I’m not trying to scare you. But I’m just highlighting the fact. Over 90% population lose money in the stock market. Why? Because they do not understand the different types of risk involved in the stocks.
A beginner who starts swimming knows that it’s dangerous if he goes in the deep water before proper training. He knows that he might even get drawn in the water. However, when it comes to stock market, people just ignore the different types of risks involved in stocks and are ready to dive in immediately.
Nevertheless, if you know the risk, the chances are that you can mitigate it or at least can have a back plan.
That’s why, in this post, I’m going to explain the 7 types of risk involved in the stocks that you should know. Further, please read the article till the end as there is a bonus in the last section.
7 Common Types of Risk Involved in Stocks
Here are 7 common types of risk involved in stocks that every stock investor should know:
1. Market risk
This is also called systematic risk and is based on the day-to-day price fluctuation in the market.
The market index Sensex and Nifty goes up and down throughout the day. And many a time, it may affect the returns from a stock. For example, if the market is going down at a time, then it might pull down the prices of even some good stocks.
Moreover, in the short term, market risks are higher compared to the long term.
2. Business Risk
The second type of stock risk comes from the business. This risk can be escalated if the business is not doing well. Reasons like the failure of management, poor quarter-by-quarter results, or your misjudgment in picking a company come under business risk.
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However, you can mitigate this risk by diversification. The chance of one business not performing well is ‘high’ compared to 5 such companies. Hence, if you are keeping 5 stocks in your portfolio, instead of one, you can reduce the business risk.
3. Liquidity Risk
Before investing in a stock, you should definitely check how solvent the company is? Companies with high debts may find it hard to pay their bills. Many times, they might even cut the dividends or in the worst case, may go bankrupt. Liquidity risks are involved in all businesses.
4. Taxability Risk
The government changes taxes all the time and hence taxes may increase or decrease in the particular industry where you invested. The change in taxation can affect the stock price.
Further, there are few industries which are taxed comparatively higher to other and hence, their net profit after tax may be less. Further, as taxation is controlled by the government, there is not much that the management or the investors can do.
For example, I’m holding the stock of ITC. During July of last year (2017), the stock price of the company fell over 15% in a day due to a news of an increase in taxation after GST in the cigarettes. A big chunk of my profit was gone that day and I couldn’t do much about it. I didn’t sell ITC because I bought it at an even cheaper price and am still bullish on this stock for long-run.
DISCLAIMER: THIS IS NOT A STOCK RECOMMENDATION, JUST MY PERSONAL OPINION.
However, before investing in this cigarette-giant company, I always knew this might happen and was willing to take the risk. Further, as a back plan, I had diversified my portfolio, which means that although ITC was down, however, other stocks in my portfolio were doing great. Therefore, the overall impact on my portfolio due to the poor performance of just one stock was quite small.
5. Interest Rate Risk
The open market or global market interest rates changes time to time. And this can positively or adversely affect the stocks depending on the direction in which the interest rate is moving. For example, when the interest rates are high, a company might find it difficult to borrow money (at high rates). Further, the bond market declines as the interest rate increases, which may also affect the corporate bonds.
6. Regulatory Risks
There are a number of regulations imposed in the different industry which must also be termed as the risk involved in stocks. For example, Cigarettes, telecommunication, beverages, pharmaceutical and few other industries are highly regulated.
If a pharmaceutical company loses any of its drug manufacturing right/permission because of a regulatory effect, then it will definitely affect the company’s profit and hence, the stock price.
7. Inflationary Risk:
With an increase in inflation, the price of raw material will increase, which can affect the production cost. Many companies involved in commodities like oil, soya bean etc are affected a lot by inflationary risk.
Further, for few industries, the inflation rate is too high. For example, education and healthcare.
The tuition fee for schools and colleges are increasing at a very fast rate. Although, it might sound good in the short term as these industries will make money from the inflated price. However, for the long run, it might have an adverse effect on retention of the customers.
Also read: Fundamental vs Technical Analysis of Stocks
Bonus: A few other risks
Besides the above mentioned 7 risks involved in stocks, here are few other risks that are worth mentioning.
- Social and political risk: Many companies face problems due to social and political risks. For example, Tata Motors shifted its Tata-Nano plant from West-Bengal to Sanand- Gujarat because of political reasons, which cost a lot of money to Tata.
- Credit Risk: The risk that the company who issued the bond won’t be able to pay the interest or repay the principal at maturity and may find it hard to buy/sell goods.
- FII/DII investments: The investment by big players can also be counted as the risk involved in stocks. If the foreign direct investment/ domestic investment decreases in a company, and they start selling their stocks, then it might adversely affect the share price of that company.
- Currency and exchange rate risk: Many companies who deals across nations or the companies involved in import/export may face a problem with increased dollar price. Therefore, the currency and exchange rate fluctuations might increase risk in these companies.
There are a number of risks involved in stocks. Nevertheless, if you understand the basic concept behind the risk involved in stocks, you can control the amount of risk you want to take.
Moreover, the risk is reduced over the long-term. A short-term fluctuation won’t hurt your portfolio in the long run. Further, most of the short-term market fluctuations, political, or social risks will be nullified while investing for a duration of 10-15 years.
Overall, yes!! There are a number of risks involved in the stock market. Nevertheless, risk-takers are awarded in the stock market if you take ‘smart’ calculated risk.
That’s all. I hope this post is useful to you. Please comment below which risk involved in stocks can hurt your portfolio the most.
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Hi, I am Kritesh (Tweet me here), an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting