Investing in the stock market offers the potential for attractive returns. However, it is not risk-free and involves exposure to various uncertainties. From market fluctuations to management effectiveness, the returns depend on several factors. Moreover, investing in stocks comes with several inherent risks, like market, regulatory, and interest rate risks.
However, most informed investors manage these risks through diversification and practising appropriate risk management techniques. Let’s discuss whether it is safe to invest in stocks by becoming aware of the various associated risks and learning how to manage them.
Risks associated with stock market investments
Needless to say, investing in the stock market can be risky. According to estimates, around 90% of market participants lose money in stock markets. However, there have been numerous occasions when the market outperformed and delivered returns higher than bank deposits and gold.
Most investors manage the stock market risk through appropriate risk management techniques like:
- Setting stop-loss orders
- Diversification across different asset classes
- Investing for the long term in fundamentally sound companies
- That said, what are the risks? Let’s see some major risks that affect stock market investments:
Market risk
It refers to the risk of losses due to price fluctuations in the overall stock market. Usually, such price changes are influenced by a variety of factors, such as:
- Economic conditions
- Geopolitical events
- Interest rate changes
- Overall market sentiment
- It must be noted that market risk affects all investments to some extent, regardless of the specific company or industry.
Company risk
Also known as specific or idiosyncratic risk, this refers to the risk associated with an individual company's performance. Several factors influencing this risk are:
- Management effectiveness
- Competitive positioning
- Product/service demand
- Regulatory issues
- Financial health
Company risk is unique to each company. You can mitigate this risk through diversification across different companies or industries. This spreads risk and eliminates the negative effect of any single investment on the entire portfolio. Most investors prefer investing in large-cap stocks, as these companies are financially stable and enjoy a strong market position.
Liquidity risk
This risk arises from the difficulty of buying or selling a stock without causing a significant impact on its price. It occurs in both:
- Individual securities
and - Entire markets
It has been observed that assets with low liquidity have wider bid-ask spreads. This makes it more expensive to trade them. Also, investors experience price volatility while trading low-liquidity stocks. The liquidity risk is usually influenced by factors such as:
- Trading volume
- Market depth
- Market structure
Taxability risk
It refers to the risk that changes in tax laws or regulations will impact the after-tax returns of an investment. It is common for governments to amend tax laws. These amendments affect both individual companies as well as the entire sector. If you have invested in a sector adversely impacted by the latest tax laws, you can sustain losses due to a decrease in the stock price.
For example:
- Say you have invested in the equity shares of a company operating in the FMCG sector.
- The government levies an additional 10% tax on FMCG companies.
- This impacts the profitability of the company.
- The investors reacting to this news sell their holdings.
- The stock prices of major FMCG companies fall.
Interest rate risk
This risk arises from fluctuations in interest rates, which directly affect the borrowing costs of a company. The Reserve Bank of India keeps changing the interest rates to tame inflation and achieve its monetary policy objectives. This usually leads to the following two situations:
- Increase in interest rate
- When interest rates increase, the loans become expensive
- This increases the interest expense of companies and reduces their profits
- Ultimately, the share price of the company falls due to impacted profitability
- Decrease in interest rate
- The RBI reduces interest rates when there is an ongoing slowdown in the economy
- This signals reduced demand for goods and services, which again negatively impacts businesses
Also read: Mid-cap stocks
Regulatory risks
These risks originate from changes in:
- Laws
- Regulations
- Government policies
Companies often face challenges adapting to new regulations, which leads to increased costs and operational disruptions. This negatively impacts the stock prices and leads to investor losses. Furthermore, regulatory risks are particularly relevant in industries that are heavily regulated, such as healthcare, finance, and energy.
Inflation risk
Inflation risk refers to the likely loss of purchasing power due to the general increase in prices of goods and services. For those who are unaware, inflation erodes the real value of money and reduces the amount of goods and services that can be purchased with a given amount of currency.
Due to rising inflation, business organisations are required to spend more to purchase their raw materials. Owing to competition, most businesses are not able to pass on this increase in production cost to their customers. This results in depleted profits and share prices.
How to manage stock investment risks?
By implementing proven strategies, investors can mitigate potential losses and enhance returns. Let us look at some proven strategies:
- Diversification
- Spread your capital across a variety of:
- Stocks
- Sectors
- Industries, and
- Asset classes
- By diversifying your portfolio, you can reduce the impact of any single stock's poor performance on your overall investment returns.
- Spread your capital across a variety of:
- Risk management techniques
- Implement appropriate risk management techniques such as:
- Setting stop-loss orders
- Using options contracts
- Stop-loss orders automatically sell a stock if its price falls to a predetermined level.
- This helps you in limiting potential losses.
- On the other hand, options strategies, such as buying put options, provide downside protection while allowing you to participate in potential upside gains.
- Implement appropriate risk management techniques such as:
- Long-term perspective
- Maintain a long-term investment perspective.
- Do not make impulsive decisions.
- Remember that stock markets can be volatile in the short term.
- But historically, they have provided positive returns over the long term.
- Hence, focus on your investment goals and stay disciplined during market downturns.
Conclusion
It is certainly debatable whether it is safe to invest in stocks. Making investments in the stock market comes with several risks, such as market fluctuations, company performance, liquidity issues, tax changes, and interest rate shifts. While these risks can lead to losses, they can be managed through diversification and risk management techniques like stop-loss orders. Furthermore, maintaining a long-term perspective is beneficial. It eliminates market volatility and helps in staying disciplined.
