Outlines some risks investors face and how you can manage them
The quantum of risk in investing in stocks is somewhere between investing in high-risk commodity derivatives and low risk debt instruments. The unpredictability associated with stock price movement claws into investor returns. While the element of risk varies from stock to stock, you must ensure your overall stock portfolio risk is in sync with your risk tolerance level.
Common risks associated with investing in the stock markets:
Developments in the markets
Sometimes, a development affects stocks of a particular company and not the market as a whole. An interesting piece of information doing the rounds in the market circles can impact investor decisions. This risk springs from the relationship between news and updates pertaining to a company, and the resultant price movements of that particular stock.
Company-specific news like strike by the workforce, legal tangle or even a fall in earnings can wane investor enthusiasm and result in a decline in the stock value. Ample diversification is the only way to eliminate this risk. It is impossible to forecast stock price fluctuations in the event of both good and bad news.
Systematic risk
Economic crisis, interest rates, political turmoil, recession and a host of other factors can cause systematic risk. Systematic risk affects the market as a whole. A broad range of securities in an investor's portfolio are exposed to systematic risk.
This risk impacts the entire markets and cannot be mitigated through diversification. Often investors try to reduce systematic risk by hedging.
Correlation risk
Correlation risk is the risk that two assets will not move up or down in value as predicted. Take a scenario where an investor invests some amount in an oil company's stock and the same amount in oil. The result of both investments in oil stock and oil is predicted to be same. As oil price moves upwards, oil stocks also go upwards. However, the correlation between the two may not be as predicted.
Correlation between stock price movements can also compound uncertainties. News pertaining to some stock can trigger fluctuations in some other stock with a high correlation.
Liquidity risk
It is the risk of a security unable to be sold in a time bound manner to prevent significant loss or reap desired profits. Stocks that are traded in low volumes are referred to as illiquid and are difficult to sell.
Sector risk
Investors who concentrate heavily on building a narrow sector-specific portfolio face the sector risk. If a government decision or news adversely impacts the sector, all the stocks in your portfolio will be impacted badly.
Market risk
This is a type of systematic risk where the investor is exposed to the burden of bearing losses from fluctuations in securities' prices.
Managing risk
Diversification: It holds the key to ironing out unsystematic risks in a portfolio. This risk management technique involves investing in a wide variety of instruments held in a portfolio. Such a well diversified portfolio will yield higher returns and be exposed to lower risk levels compared to a poorly-diversified portfolio.
You can benefit from diversification if the securities in your portfolio are not perfectly correlated. In such a scenario, even if one asset or sector is faring poorly, the gains on other assets can make up for this loss.
Match risk tolerance level: You must invest in stocks that suit your risk tolerance level and financial goals. A person with a high risk appetite can buy mid-cap stocks and growth stocks. Large-cap stocks are more reliable though their pace of growth may not be phenomenal.
