Wednesday , 24 July 2024

5 Risks Of the Stock Market

…There are many risks within the market that leads an investor to making or losing money…but being proactive and reducing all of the risks you can will lead to less volatility and more growth over the long term. Let’s look at 5 risks of the stock market.

The original article has been edited here by for length (…) and clarity ([ ])

#1. Market Risk

This risk is what you face when you invest in the stock market. On any given day the market could rise or it could fall. Unfortunately there is nothing you can do about this. As a result, this is the one risk you cannot reduce or eliminate other than not investing in the stock market in the first place…

#2. Business Risk

Another of the risks of the stock market you cannot control is business risk. This is the risk of being in business. For example, you might read through financial statements and filings and after your research is done, decide that a specific company is a good place to invest your money but then, a few months later, something happens and the stock and the business get hammered…

You as an investor cannot control this. It is part of doing business and can happen to any business at any time but you do have some options to reducing this risk. Your primary option is diversification. By making sure you invest your money in a handful of companies, you reduce the business risk you face. After all, the odds of every company you invest in facing issues at the same time is slim.

#3. Inflation Risk

…While investors have no control over how quickly or slowly inflation will grow, historically it runs at a 3% annual rate. Therefore, investors need to average more than 3% annually to come out ahead.

…By investing in a portfolio of different sized companies, as well as bonds, you increase the likelihood of you achieving a rate of return that is higher than inflation.

#4. Interest Rate Risk

Interest rate risk affects bond investors a lot. If you invest in bonds, you have to pay attention to interest rates because interest rates and the value of bonds move in opposite directions. For example, when interest rates rise, bond prices tend to fall and, when interest rates fall, bond prices tend to rise.

Let’s look at an example to make this concept clearer. Say you are holding a 30 year bond that is paying 4% interest. Interest rates start to rise and newly issued 30 year bonds are paying 6% interest. Any new investor looking to buy a bond is going to want the bond paying 6% since they can earn more money on it. The result is lower demand for the 4% bond and as a result, a lower price.

The way to control this risk is to invest in bonds of various maturity levels. Rising interest rates tend to have a bigger impact on longer term bonds. As a result, it makes sense to invest in both long term and shorter term bonds.

#5. Reinvestment Risk

This risk is also related to bond investors. When you invest for income, you need to earn a certain level of interest but you have no control over when interest rates rise or when they might fall. You could easily find yourself in a position of a 30 year bond that pays 6% maturing and your only option is a new 30 year bond paying 3%. Having your income cut in half is not ideal and not possible for many investors.

To overcome this risk when investing, you should build a bond ladder. This works by having you divvy your money into 3 or 4 buckets and investing in various term bonds. For example, if you have $25,000 to invest, you might put $6,250 into each of the following:

  • 1 year bond
  • 5 year bond
  • 10 year bond
  • 20 year bond

When the 1 year bond matures, you reinvest that money back into another 1 year bond. When the 5 year bond matures, you reinvest that money into another 5 year bond. The idea is that by investing your money in different maturity bonds, you decrease reinvestment risk since you are investing your money at different times and not all at once.

Final Thoughts

The 5 risks of the stock market mentioned above…tend to be the ones that trip up most investors. Make sure you take the time and do what needs to be done so you can reduce the risks you face when investing. By being proactive and reducing your risks, you can still achieve a desired rate of return and not face higher levels of volatility you would otherwise face.

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