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“The greater the risk, the greater the reward” is heard everywhere, including when it comes to the stock market. Riskier assets, such as emerging market stocks are riskier than bonds, and as a result, lead to greater returns over time. But what exactly is risk? The definition of risk is exposing oneself to danger, harm or loss. But risk is a general term. There are many examples of risks when investing. In this post, I will introduce you to most of the forms of risk when investing in the stock market.
9 Risks When Investing You Need To Understand
#1. Business Risk
Business risk is simply being involved in an industry. For example, a company that does business selling cars runs the risk of not selling cars because of a recession in the economy or a hiccup in production. The company cannot control this risk.
A perfect example is the Firestone tire issue a few years ago. As a result of faulty tires, both Firestone and Ford faced serious business risk.
As an investor buying shares of said company, you face this risk. If the company isn’t selling cars, the stock price will drop.
#2. Market Risk
This is the risk you take when investing in the stock market. If the market drops, you lose money and vice versa. This is due to the market as a whole declining and not a result of a specific security losing value.
Every day, market risk presents itself again as no one knows what the market will do that day. It is a risk that you cannot avoid when you invest in the stock market. As an investor, you just have to take it into account.
#3. Currency Risk
Another example of one of the risks when investing is currency risk. If you invest in foreign companies, you can lose money simply by having the dollar appreciate or depreciate in value. When this happens, the value of the foreign company shares is worth more or less to you.
You saw this happen when the UK decided to leave the European Union. The value of the British Pound dropped greatly in value. If you were investing in any UK stocks, you took a hit.
You also face this risk when you trade in currencies as well. This risk is not limited to just stocks, but forex trading as well.
#4. Credit Risk
If a company issues bonds to the public and then defaults on the payments or enters into bankruptcy, you risk losing your money.
This can be a large issue since so many companies issues bonds with a time horizon of 5 years or longer. You have no idea what is going to happen in the future. Just ask Lehman Brothers bondholders.
The good news with credit risk as it relates to bonds is that as a bondholder, you are first in line to get your money back. This isn’t to say you definitely will get your money back, but you have priority versus stockholders.
#5. Inflation Risk
Inflation risk is one of the biggest risks when investing. It is also a risk to non-investors as well. Because prices rise over time, a dollar today is more valuable than a dollar tomorrow. This is due to inflation.
For example, if inflation is running at 3%, an item that costs you $1 today will cost you $1.03 tomorrow.
When you invest, you risk having your investments worth less over time due to inflation. This is why the best time to start investing is now. The sooner you start, the sooner you can begin to earn the market rate, roughly 8% annually, which helps offset inflation risk.
#6. Interest-Rate Risk
The value of bonds decreases as interest rates rise. In some instances, the value of stocks also decline when interest rates rise. When you invest during a time of rising interest rates, you risk losing money.
This is more of an issue with longer term bonds as opposed to short term bonds. When you think about it, it makes sense. If you are holding a 20 year bond that is yielding 3% and suddenly interest rates jump to 5%, you want that new bond, not the one you currently have.
As a result, you sell your bond for less money since there is less demand. With a short term bond, most people won’t go through the process of selling if the bond is maturing in a year.
#7. Liquidity Risk
Of all of the risks when investing, not many investors face liquidity risk. This risk refers to your ability to sell the shares you own to someone else for cash. If you own IBM, it is fairly easy for you to liquidate (sell) the shares and get money. Conversely, if you own stock in your neighbor’s start-up side business, it will be much more difficult to find a buyer.
When I worked for a high net worth financial planner we encountered this. A lot of our clients were invested in a real estate investment trust. After a few years, the promised rate of return was not happening so most wanted out.
The problem was that in order to sell, you had to have a buyer lined up. Not many people were interested and those who were, didn’t have the capital to actually buy the trust units.
#8. Prepayment Risk
When bond issuers pay back the money owed to bondholders early, the bondholders face prepayment risk. They will not have earned the money they thought they were going to. Another way to look at prepayment risk is with your mortgage.
When you prepay your mortgage, you are lowering the total amount of interest you pay over the life of the mortgage. As a result, the lender will not earn the money he thought he was. This is good for you, bad for the lender.
Same idea applies with a bond. Prepaying is good for the company, but bad for the bondholder.
#9. Reinvestment Risk
When interest rates drop, companies that have debt outstanding (bonds) typically pay off the bonds early and issue new bonds at the lower rate. This causes investors to reinvest at a lower interest rate as well.
Another example would be a retiree investing in bank CDs. They run the risk that when a CD matures, interest rates will be lower than before. They are risking reinvesting at a lower rate.
Again, these are most of the risks when investing your money. Some matter more, some less and not all apply to every investor. The key is to be aware of them. Luckily, with some of the risks mentioned, you can reduce your exposure to them through diversifying. For example, creating a CD ladder will lessen your exposure to reinvestment risk.
There is one risk however that you cannot lessen, market risk. It will always be there, no matter what type of investment you chose to invest in. Even if you diversify into stocks and bonds, you are still invested in the market and the risk is always there. But if you follow a few basic steps, you can become an successful investor.
[Photo Credit: stevepb]