What Risks Are Involved With Stocks?
"No pain, no gain." Or, as an investor is more likely to put it, no risk, no reward. While it is impossible to entirely eliminate risks when buying stocks, understanding the risks is the first step towards making them manageable.
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To understand the risks involved with stocks, it is important to understand what is a stock. Common stock represents an equity interest in a company, meaning a share in the value of the company after all its liabilities are paid. As such, it is an unsecured position that is subordinate to bond holders and other creditors in the case of liquidation. If there's no equity left in the company, then there is essentially no value to the stock.
Types
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So, it's clear the value of a stock can go to zero, but that's a worst case scenario. Most often, investors simply experience moderate to heavy losses without being entirely wiped out. There are two types of risk associated with stocks, those that stem from the fundamentals of the specific company, and those that flow from the mechanics of the market. Business involves inherent risk related to individual performance and the overall economy. On the other hand, sometimes the movements of stocks have nothing to do with the fundamentals. Systemic, or market risks, involve changes in risk appetite, multiple contraction, hedge or mutual fund liquidations and sector rotation.
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Identification
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Sometimes a stock is halted when news is pending, preventing a stock holder from buying or selling, and the price will be significantly different once trading is restarted. Every quarter, a company releases its earnings results and conducts a phone conference, which will often create volatility in a stock, sometimes in unpredictable directions. Traditional research is best suited to identify and mitigate these kinds of risks associated with the performance of the individual company.
Effects
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It's the nature of the market that big money has a big influence and small money can only try to go for the ride. And, what makes systemic market risks so devious is that their difficult to foresee and are usually not generally recognized until after the fact. For example, institutional investors will often rotate through different sectors of the market, fluctuating stock prices without fluctuations in the performance of individual companies. It's only after an unusually large and broad sell-off that the influence of a large hedge fund forced to liquidate their assets will be identified. Once panic grips the market, stock trading can become irrational and very hard to predict.
Considerations
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Other risks involved with stocks are more larger in scope and time frame. Inflation, for example, is the erosion of value over time and can turn a small gain into a loss. In normal times, inflation eats up 2 to 4 percent of profits every year. Over decades, that means stocks have to appreciate significantly just to break even when adjusted for the lower purchasing power of money resulting from inflation. Economies also move through multi-year cycles and some stocks are more closely linked to the up and down of the economy than others.
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- Photo Credit Bantosh (GNU 1.2)
