Types of Risks Involved in Investing in the Stock Market
Investing in the stock market is a great way to make money specially when you are investing for the long term. However, there are some risks involved which may well be outlined for you for your better understanding of the stock market. These types of risks are as follows:
- Volatility: Volatility refers to price fluctuation of a stock or security over a period of a year. Not just the stock itself but also the market may be affected by volatility across the board. Volatility can occur due to the following reasons in general:
- Geopolitical Events: In a connected world where economies and politics are all connected, an event occurring in one economy can have an impact on another. For example, a recession or an economic downturn in the U.S. can have an adverse impact on economies globally. Similiarly, a military threat posed by one country to another, can have an adverse affect on the economies of both the countries and/ or the countries of the region.
- Economic Events: Any significant change in the monetary policy, tax regulations, GDP growth, export and import figures etc, or even the weather can have an impact on the economy of a country. This in turn causes volatility in the local markets.
- Inflation: The rising costs of goods and services or deliberate government action along those lines can impact the future value of assets such that income may be reduced on account of less purchasing power. Inflation can cause volatility in the markets.
The above three factors can impact the volatility of stocks or securities and make the market go up or down in accordance with the unfurling of events or the rise and fall of inflation. There are a few ways to manage or deal with volatility. These include buying stocks with consistently rising dividends, adding bonds to your portfolio (as bonds are generally stable, fixed income instruments) or reducing exposure to stocks or securities which are highly volatile. Timing: Trying to predict how the market will play out in the future and accordingly invest in the market is called timing. It is logical to think that one should buy when the market is at a low and sell when the market is at a high. That seems like sound advice. While it is easy to think that way, it is not easy to implement the same. This is because there is no way to tell if a market has reached its low-point or high-point. Everything is relative. So it is very possible that what you think is the market- low and invest in it, may actually turn out to be a market high, wherein the market takes a further downturn from your entry point.
In order to manage this timing risk, one can employ the use of what is called Rupee Cost Averaging. This means a constant amount of rupees is invested when the price of a stock falls resulting in greater number of stock bought and investing the same amount when the price of a stock rises resulting in lesser number of shares purchased of the same company. This results in having greater number of shares of a company at an averaged-out cost. This can help you as an investor against market fluctuations and downside risk.Overconfidence:Overconfidence in one’s abilities may lead to errors of judgement, thereby resulting in wrong investment decisions. Failure to recognise your biases towards certain stocks, too much concentration in a single stock or industry, very high amount of leverage, and being on the sidelines of the stock market for too long are some of the effects of overconfidence.
In order to beat the impact of overconfidence, one must stay grounded and use strategies to reduce the effect of overconfidence. These strategies include:
- Diversification: Try to spread your risk by purchasing different stocks belonging to different industries. Buying five or ten different stocks spread over different industries is a good idea. Better yet, you may as well invest in ETFs or mutual funds to have automatic diversification of your portfolio.
- Long-Term Investments: Holding your stocks for the long term is a good idea to beat the effect of overconfidence. Particularly, if you invest in good companies for the long term, such as 10 years or more, you are bound to reap good returns from such investments.
- Do Not Leverage: Try not to leverage your purchase based on borrowing as holding shares in custody is a far better proposition than buying shares against borrowed money. This way you can protect yourself against market and stock downturns or any crisis in the economy or the stock market.
So the three main types of risks involved in investing in the stock market are volatility, timing and overconfidence. The ways to manage and curb these risks have also been briefly outlined for you to have a smooth and productive investment experience. So, go ahead, take a plunge and invest in the stock market, keeping these risks and mitigating factors in mind, in order to earn good returns from your investments.