Last updated on May 6, 2024
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Market risk
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Liquidity risk
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Credit risk
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Inflation risk
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Behavioral risk
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Here’s what else to consider
The stock market can offer attractive returns for investors, but it also comes with various risks that can affect your portfolio performance and financial goals. In this article, we will discuss some of the most common risks when investing in the stock market and how you can manage and mitigate them.
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- Giulio Renzi Ricci Head of Asset Allocation, Europe at Vanguard
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1 Market risk
Market risk is the possibility of losing money due to fluctuations in the prices of stocks or the overall market. Market risk can be caused by factors such as economic conditions, political events, natural disasters, or investor sentiment. You can reduce market risk by diversifying your portfolio across different sectors, regions, and asset classes, as well as by using strategies such as hedging, stop-loss orders, or dollar-cost averaging.
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- Thomas Praz Multi-Asset Sales Trader at Banque Cantonale de Genève
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A security can be more or less volatile and subject to price fluctuations that deviate from its expected return.In portfolio theory, diversification can be an efficient tool to reduce the volatility of a portfolio. By mixing different asset classes, which have low or negative correlation to one another, the overall portfolio volatility can be lower than the weighted average volatility of its components.
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- Shakeel Jeeroburkan ACSI Asset Management Operations at Fidelity International (Open to Work)
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The rapid evolution of technology can render certain sectors obsolete, while boosting others. Investors can counteract this risk by staying informed about global technological trends and adjusting their portfolios accordingly, potentially benefiting from sectors poised for growth due to technological advancements.
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2 Liquidity risk
Liquidity risk is the risk of not being able to buy or sell a stock quickly or at a fair price due to low trading volume or high volatility. Liquidity risk can result in losses or missed opportunities if you need to exit or enter a position urgently. You can avoid liquidity risk by choosing stocks that have high liquidity, such as those listed on major exchanges, or by trading during peak hours when the market is most active.
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Try to avoid illiquid stocks if you are a trader. Hence, a long-term investor might do invest in illiquid assets. A trader should look for liquid stocks.
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- Shakeel Jeeroburkan ACSI Asset Management Operations at Fidelity International (Open to Work)
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This risk in the stock market often correlates with market depth and investor behaviour. A stock's liquidity can significantly fluctuate based on corporate news or sector specific developments, impacting the ease of trade. An effective strategy to mitigate this risk is to monitor news and trends closely, which may signal changes in liquidity, enabling investors to make timely decisions before major liquidity shifts occur.
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3 Credit risk
Credit risk is the risk of losing money if the issuer of a stock or a bond defaults on its obligations or becomes insolvent. Credit risk can affect the value and income of your investments, as well as your ability to recover your principal. You can minimize credit risk by checking the credit ratings and financial health of the companies you invest in, and by diversifying your portfolio among different issuers and industries.
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- Thomas Praz Multi-Asset Sales Trader at Banque Cantonale de Genève
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Credit spread is the market mesure of credit risk, which is the pickup in yield for a credit security (corporate bond for example) compared to its benchmark.Credit spreads incorporate the market expected probability of default and recovery rate for a particular investment.Additionally, in the event of a default, the value of your investment does not necessarily go to zero. Depending on the seniority of your claim and the allocation of collateral, a percentage of your invested principal can be recovered.Diversification is key when investing in credit securities. A fixed income portfolio can recover from the default of a borrower, given its exposition is not too concentrated.
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- Shakeel Jeeroburkan ACSI Asset Management Operations at Fidelity International (Open to Work)
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Credit risk is intrinsically linked to the financial stability of companies in which one invests. Beyond mere credit ratings, investors can mitigate credit risk by analysing industry trends and economic cycles that might impact a company's revenue and debt management capacity. This approach aids in identifying companies with robust business models capable of weathering economic downturns, thereby reducing potential credit risk exposure.
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4 Inflation risk
Inflation risk is the risk of losing purchasing power due to the rise in the general level of prices over time. Inflation risk can erode the real value and returns of your investments, especially if they have low or fixed interest rates. You can combat inflation risk by investing in stocks that have high growth potential, or in securities that are indexed to inflation, such as Treasury Inflation-Protected Securities (TIPS).
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- Giulio Renzi Ricci Head of Asset Allocation, Europe at Vanguard
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Over the long term, equities have proved to be very effective securities to contrast the eroding power of inflation, and deliver positive real returns. In my experience, what investors are mostly worried about is inflation risk over the shorter-term, especially when inflation volatility is high, driven for instance by a supply side shock (e.g., war) and increasing energy costs. Over the shorter term, investors should look for high inflation beta assets, to protect their portfolio from inflation risk. These are assets whose return moves close or higher than the rate of inflation. Commodities, for instance, tend to have inflation betas close to 2, making them very effective securities for hedging unexpected inflation.
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- Shakeel Jeeroburkan ACSI Asset Management Operations at Fidelity International (Open to Work)
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Inflation risk affects the real returns of investments. It's important to understand that different sectors react diversely to inflationary pressures. For instance, industries like real estate often benefit from inflation, whereas others may suffer. A nuanced approach to inflation risk involves investing in sectors that historically demonstrate resilience or growth during inflationary periods, thus potentially offsetting the eroding effects of inflation on investment returns.
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- Thomas Praz Multi-Asset Sales Trader at Banque Cantonale de Genève
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Companies which have a strong pricing power can adapt their pricing to offset the inflation impact on their costs.Dividend-paying stocks, which grow their earnings per share and increase their dividend distributions while possessing a strong pricing power, are one of the investments, which shield returns from inflation in the long run.Teasury Inflation-Protected Securities (TIPS) offer higher returns when realised inflation is higher than the market implied expected inflation, and lower returns when realised inflation is lower than expected inflation.Thus, having TIPS in your portfolio before any sign of strong inflation can be a good hedge for a potential inflation shock, but buying them too late or too early is counterproductive.
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5 Behavioral risk
Behavioral risk is the risk of making irrational or emotional decisions that deviate from your investment plan or objectives. Behavioral risk can be influenced by cognitive biases, such as overconfidence, loss aversion, or herd mentality, that can lead you to buy or sell stocks at the wrong time or for the wrong reasons. You can overcome behavioral risk by following a disciplined and systematic approach to investing, based on your risk tolerance, time horizon, and goals, and by avoiding emotional reactions to market movements.
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Behavioral risk has gained increasing recognition in the finance world, especially post the 2008 financial crisis, which underscored the impact of human psychology on financial markets. Today, with volatile markets and a deluge of information, understanding and managing behavioral risk is more relevant than ever.One must not underestimate the difficulty of overcoming deeply ingrained cognitive biases. Further we must address the potential limitations of a disciplined and systematic approach in a rapidly changing market environment.
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- Mark Higgins, CFA, CFP® Institutional Investment Advisor | Award-Winning Author of Investing in U.S. Financial History
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Overconfidence is the Most Common and Costly Bias of Investors*********************The wisdom of crowds prevents the vast majority of investment professionals from outperforming broad market indices. This law dictates that the collective pricing estimates embedded in millions of trades is much more likely to be accurate than the individual guess of an individual investor (assuming market manipulation and insider trading is not in play). Most investors refuse to recognize this reality. Even those who succeed in the short-term often mislabel their performance as skill rather than luck. This being the case, the greatest risk to investors is falling victim to the belief that they can outsmart the market.
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Behavioral risk is a subtle yet significant aspect of finance, exposing investors to their own psychological biases. Unlike other risks that can be communicated, behavioral risk is more challenging to detect and manage. When investing, individuals confront their own beliefs and biases, testing their convictions, particularly in volatile markets. Without a clear plan for exiting unsuccessful investments, an investor may feel directionless. The temptation to change the adjust stop-loss parameters, or the absence of them, leaves one vulnerable to emotional decisions. Establishing exit strategies and stop-loss parameters is essential to mitigate such risks and maintain investment discipline.
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6 Here’s what else to consider
This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?
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- Shakeel Jeeroburkan ACSI Asset Management Operations at Fidelity International (Open to Work)
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Here are some other risks to consider: 1️⃣ Interest Rate Risk:This affects stocks sensitive to rate changes, and can be managed by diversifying into less affected sectors. 2️⃣ Currency Risk:This is significant in international investments, and requires strategies like currency hedging to mitigate exchange rate volatility. 3️⃣ Political Risk:Stemming from governmental changes or geopolitical tensions, can be reduced by geographic diversification. 4️⃣ Sector-Specific Risk:This risk, linked to industry-specific factors, suggests the need for a portfolio diversified across various industries to minimise exposure.
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- Hrishikesh Agarwal Credit Risk Analyst - Kotak Mahindra | XIMB MBA-BM'23 | NISM Certified | Momentum Investor | Former Treasurer @ X-SEED, The E-Cell of XIMB
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In addition to all the risks mentioned, one more risk is the opportunity cost risk. In the stock markets, the risk of opportunity cost arises when you invest in one stock, potentially missing out on gains from another that might have performed better. While this can only be judged in hindsight, there are two ways to minimize the risk of opportunity cost:1. Price Stop Loss - This is the maximum loss that you are willing to take on a particular stock and you sell the stock when it falls below your stop loss.2. Time Stop Loss - This is the maximum time that you are willing to hold a stock without any significant gains. This might range from one week to one year or even more depending on the horizon or risk appetite of the investor.
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