6 Forms of Risk You Encounter When You Invest in Stocks

Every type of investment carries risk, even those that are traditionally considered to be safe, such as bonds. Most people recognize that stocks are among the riskier investments, but they’re not always aware why this is so.

Obviously, the ultimate risk in investing is that you could lose money. However, this can happen in many different ways when you’re investing in stocks. Understanding the different types of risks associated with equities can help you mitigate them while also staying within your own risk comfort level. Some of the key risks involved in investing in stocks include:

  1. Market Value Risk

You can’t control how the market will move, and sometimes it will move away from you. This can happen when new and exciting opportunities become available and the spotlight moves away from companies that are considered old or boring.

While market value risk can hurt you if you invested a lot of money in something when it was the hot new thing, investors can often use this risk to their advantage. For example, when the price of a solid investment falls because attention moves elsewhere, investors can buy shares for cheap and bet that they’ll appreciate over time. Market value risk also highlights the importance of diversification. When you have all your money invested in one sector that takes a nosedive, your portfolio can suffer.

  • Economic Risk

While market value risk depends on the sentiment of other investors, economic risk really relates to the performance of the economy itself. Perhaps the best example of this is the 2008 financial crisis, which caused massive downturns across the vast majority of industries.

When the whole economy takes a hit, you cannot depend on diversification to help you out since your whole portfolio will likely suffer anyway. (Diversification is still wise, however.) In these situations, you often need to hunker down and ride out the storm. Try to take a long-term view, and remember that, over the decades, the market trends up. Constantly buying and selling is a poor strategy. In addition, downturns can present another opportunity to buy great stocks for discounted prices if you have extra cash on hand. Otherwise, you need to reduce spending and wait for the economy to recover.

  • Overconfidence Risk

If your portfolio has seen excellent returns, you may risk becoming overly confident. People often talk about how you shouldn’t invest based on emotion, but the overconfidence trap is less often discussed. Have a clear strategy for investing that you stick to over time. Try not to get too lax in your approach or deviate just because you think you’re doing well. Ultimately, you are likely doing well because of your strategy, so maintain it. Check your biases and make sure you are not letting yourself get swayed by conscious or unconscious emotions. Also, avoid trying to time the market; even the professionals find this nearly impossible and you could end up losing big.

  • Legislative Risk

Often, legislative risk affects international investments although it can also apply to domestic stocks. The term refers to the possibility of government action interfering with your investment. If a new government policy or action interferes with the business of the company you’ve invested in, its stock value can fall considerably. Legislative risk also varies quite a bit between industries, but virtually every company is subject to it to some extent. The government has the ability to step in whenever a company or industry is endangering the public and refuses to self-regulate—this can benefit investors in some cases, especially when it promotes competition or prevents the collapse of an industry. However, governments can also over-regulate, which means that legislative risk is a real consideration for investors, especially if your investments are in hot-button areas.

  • Inflationary Risk

One of the major risks when investing in bonds, inflationary risk also applies to stocks. When inflation becomes too high, the purchasing power of a currency falls, and recessions can result. In times of very high inflation, investors often turn to hard assets like gold and real estate since these investments often withstand the changes in price. Companies like stocks because they can change the price of shares according to the rate of inflation. This increase also benefits shareholders.

However, if a recession occurs, stocks will likely struggle and their prices will decline. This decrease in prices can last for quite a while until the economy recovers enough to bear higher prices. Stock market investments can be valuable during times of inflation, as long as the economy is not driven to the point of recession.

  • Conservativeness Risk

For the most part, there’s nothing wrong with being conservative in your approach to investing. However, it’s important to recognize that you will likely struggle to reach your financial goals if you don’t take on any risk at all. This hesitancy is, in itself, a risk. If you keep all of your money in low-risk investments, your return may not be high enough to get you to your goals. Ultimately, you may not even earn more than the rate of inflation, which would mean that you actually lost purchasing power.

In general, younger investors can be more aggressive with their stock market investments, since their portfolios will have time to recover from losses. If you are younger, consider whether you’re being too conservative and if you might take on more calculated risks. As you get older, you can reduce your risk exposure.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: