Stock investments are one of the best ways to generate wealth. A strategic investment plan and data-driven decisions can help any investor achieve their long-term financial goals effectively using stocks. Every investment has some form of risk associated with it. The investment world works on a simple principle of risk-reward: higher risk offers a better possibility of earning higher returns and vice versa. Therefore, stock investments carry certain risks that all investors need to be aware of. Today, I will be talking about the risks associated with making a stock market investment and how you can manage those risks efficiently.
Before I talk about risks, I would like to quote Mr. Benjamin Graham (Value Investing):
“Successful investing is about managing risk and not avoiding it.”
To manage risks, you need to know what risks you will have to deal with.
In this article
- Risks Associated With Stock Market Investments
- How to Manage Stock Investment Risks?
Risks Associated With Stock Market Investments
First things first, as an investment avenue, stock investing is risky. While you can reduce the risks, it will not be as safe as a bank fixed deposit. Having said that, stock investments have historically outperformed investments in fixed deposits, gold, etc. If you plan your investments well, this can be a great way to put your hard-earned money to work as hard as you to fulfill your goals. Here are some risks associated with a share market investment:
#1. Market Risk
The price of a stock is determined by the demand and supply of the said stock in the share market. Hence, it fluctuates every day and within the day too. As an investor, you buy stocks and earn gains either through the dividends declared by the company or by selling it at a higher price. However, when you need to sell the stock, if the price is low, then you stand the chance of booking losses. This is market risk.
#2. Company Risk
A share is a piece of ownership in the company. If the company faces problems in business, then the stock price can fall. Most investors analyze the financials and management of the company before investing in its stock. Hence, a problem there can lead to a price drop.
#3. Liquidity Risk
Since dividends are a good source of regular income in stocks, the solvency or liquidity of the company is crucial. A company with liquidity problems can cut back on dividends or worse, find it difficult to clear its bills or repay its debts. This can have an adverse effect on the stock price of the company.
#4. Taxability Risk
I am referring to the tax laws governing the company whose stock you have purchased. The government keeps changing tax rules based on the needs of the economy. If the sector you have invested in gets adversely affected by any such tax laws, then the stock price can fall within no time.
#5. Interest Rate Risk
The government also changes the interest rates on deposits and loans based on the direction in which the economy is headed. Hence, if the interest rates increase, companies get loans at higher rates that can cut into their profits and affect the stock price. On the other hand, if interest rates fall too low, then it is an indication of a slowdown in the economy, and businesses suffer losses too. Hence, a balanced interest rate regime is healthy for the stock markets.
#6. Regulatory Risks
Many sectors are governed by regulatory bodies. For example pharmaceuticals, tobacco, telecommunication, etc. Any change made by the regulator can impact the business of all companies in the sectors causing a price drop.
Inflation is an overall increase in the price of commodities and products. When the inflation rate increases, companies have to spend more to procure the same amount of raw material. A sudden rise in inflation rates can impact the profitability of companies causing a drop in share prices.
There are various other risks like political risk, social risk, currency risk, etc. In simpler terms, there are many factors that can impact stock prices. Hence, the answer to the question – is it safe to invest in stocks depends on how you manage these risks.
How to Manage Stock Investment Risks?
This is the meaty part of the article. I will try to keep it simple and offer some implementable tips to help you manage stock market risks and offer an answer to the perennial question – is it safe to invest in the share market?
You might have heard this term a lot of times in almost all investment-related articles. Remember the adage ‘don’t put all your eggs in one basket’? If you do and the basket falls, then all the eggs can get broken. The same holds true for stock investments. If you invest a huge portion of your money in stocks of companies from a sector and the sector experiences difficult times, then you can suffer huge losses. Therefore, it is important to ensure that you spread your investments across multiple stocks.
Diversification is effective when you invest in stocks of companies that have zero or low correlation with one another. In simpler terms, invest in market segments in a manner that if one segment falls, then the other does not automatically fall too.
Apart from diversifying across sectors, also ensure that you don’t focus too much on large-cap, mid-cap, or small-cap stocks alone. Invest in companies of different sizes to minimize risks affecting any one segment.
#2. Research the company before investing
Another good way of managing the risk of investing in stocks is to ensure that you research the company well before buying its stock. Look at the company’s financials and assess if it is sound enough to weather the economic ups and downs. Also, fundamentally strong companies are generally preferred by investors who drive the price high.
#3. Avoid emotion-based investment decisions
The investors of today have a lot of information available via news channels, blogs, online articles, etc. While every ‘expert’ claims to help them earn massive returns, getting drawn into an investment without proper research can be counterproductive.
Also, during an economic slowdown or recession, panic can lead investors to make rash decisions that can lead to losses or further enhance the risk of the portfolio of stocks. Hence, it is important to ensure that you always make data-driven decisions and keep speculation at bay. Remember, stock investing is NOT gambling.
#4. Don’t invest and forget; keep track
Stock markets are inherently volatile. Hence, if you hold a portfolio of stocks, then there can be times when certain stocks need to be sold and some new ones must be purchased to optimize the returns. You can identify these opportunities if you regularly track your investments. Once a fortnight is good but you can increase or decrease the frequency based on the kind of stocks you have invested in.
#5. Invest in defensive stocks
Conceptually, defensive stocks are ones that belong to companies selling essential goods and services. Think healthcare, groceries, etc. Regardless of the state of the economy, people will spend on these products/services. Hence, while market volatility affects them too, the stock prices of such companies are relatively stable. Hence, by ensuring that you dedicate a portion of your investible corpus to such stocks, you can reduce the overall risk of your investment portfolio.
#6. Add some high-dividend paying stocks to your portfolio
Even if you are not looking at regular income in the form of dividends from your equity investments, companies that offer consistent and high dividends are considered strong companies. Therefore, unless they slash the dividends, such stocks tend to perform better than others from the same sector. Hence, while investing in a particular sector or market segment, ensure that you include high-dividend paying stocks too.
#7 Invest According to your risk tolerance
Now that you have a fair idea about the risks associated with stock investing and ways in which you can manage them, I would also like to highlight an important aspect that you need to keep in mind while investing – always invest according to your risk tolerance.
Every investor is different and has a different level of tolerance to risk. While someone might be willing to bet on the proverbial dark horse or take high risks with his investment for an opportunity to earn great returns, someone else would be comfortable with lower returns as long as he takes lower risks. It is important to invest according to your risk tolerance levels to keep emotion-driven decisions at bay.
For example, if a person with a low-risk tolerance invests in small-cap stocks and the market falls for a few days in succession, then he can panic and sell the stocks, booking a loss. However, an investor with a high-risk tolerance will probably hold on to the investment without panicking or make a sale decision sooner, minimizing his losses.
Regardless of the market condition, rather than asking is it safe to invest in stocks right now, think about how you can make it safer for you to invest in stocks and maximize your returns.