Understanding risk and volatility are two of the most important things to keep in mind with the stock market.
There are many different types of risk in the stock market. Some are direct, such as a small company that has the potential to make gains because of innovative products. Others are indirect and external. You can’t manage all types of risks.
Some come out of the blue, like the 9/11 terrorist attacks or the 2008 financial crash. So, if you think that you can control every form of risk, take a deep breath and realize you can’t.
Don’t let risk frighten you. After all, life itself is risky. Just make sure that you understand the different kinds of risks that I discuss in this article before you start navigating the investment world. Be mindful of risk and find out about the effects of risk on your investments and personal financial goals.
1. Financial risk
When investing in stocks, you run the risk of losing your money if the company whose stock you purchase loses money or goes bankrupt. This is the most obvious risk since companies do go bankrupt.
By doing adequate research and selecting your stocks carefully, you can greatly increase your chances of the financial risk paying off. Even when the economy is doing well, financial risk is a concern. You can reduce your financial risk with a little research, planning, and common sense.
During the late 1990s stock investing mania, millions of investors (including many well-known investment gurus) ignored some obvious financial risks of many then-popular stocks. Investors invested in bad stocks blindly.
Consider investors who invested in DrKoop.com, a website that provides health information, in 1999 and held on throughout 2000. There was no profit, and the company was overfunded. As DrKoop.com’s share price fell from $45 to $2 by mid-2000, it went into cardiac arrest. When the stock went DOA, investors lost millions.
The graveyard of stock market catastrophes in 2000–2001 was littered with internet and technology stocks because investors didn’t understand (or didn’t care) about the risks involved with companies that didn’t offer solid results (profits, sales, etc.). When you invest in a company that has no track record, you’re speculating rather than investing.
Let’s fast forward to 2008. As headlines raged about the credit crisis on Wall Street and the subprime mortgage crisis following the housing bubble burst, new risks emerged. As the market went through this stomach-churning rollercoaster ride, think about how this crisis affected investors.
Bear Stearns (BSC), caught in the subprime buzzsaw, was an example of a casualty you would not want to be a part of. By March 2008, Bear Stearns was trading at $2 per share, down from $170 a share in early 2007. A massive overexposure to bad debt led to its problems, and investors could have done some research (the public data was revealing!) and avoided the stock entirely.
Internet stocks (as well as Bear Stearns, among others) have the hallmarks of financial risk – high debt, little (or no) earnings, and a lot of competition. Some investors avoided huge financial losses by steering clear. Some investors were lured by the status of these companies and lost their shirts because they failed to do their homework.
Those who lost money by investing in these trendy, high-profile companies don’t deserve all of the blame; some prominent media sources and analysts should also have known better.
It may one day be studied as a case study of how euphoria and the herd mentality ruled the day (temporarily), rather than good, old-fashioned research and common sense. There are times when the excitement of making a fortune gets the best of people, and they throw caution to the wind. Historians may look back at those days and say, “What were they thinking?” To achieve true wealth, one must work hard and conduct thorough research.
When it comes to financial risk, a healthy bottom line means that a company is making money. By investing in a company that is making money, you can also make money. If a company doesn’t make money, you won’t make money if you invest in it. Profits are the lifeblood of every business.
2. Interest Rate Risk
Interest rate risk may sound like an odd risk to investors, but it’s a common consideration for investors. Even something so harmless as “interest rates have changed” can cause you to lose money.
There may be times when interest rates change on a regular basis, causing some challenges. Interest rates are set by banks, and the Federal Reserve (the Fed) is, in effect, the country’s central bank.
The Fed raises or lowers its interest rates, actions that, in turn, cause banks to raise or lower their interest rates accordingly. Interest rate changes affect consumers, businesses, and, of course, investors.
Here’s a generic introduction to the way fluctuating interest rate risk can affect investors in general: Suppose that you buy a long-term, high-quality corporate bond and get a yield of 6 percent. Your money is safe, and your return is locked in at 6 percent.
Whew! That’s 6 percent. Not bad, huh? But what happens if, after you commit your money, interest rates increase to 8 percent? You lose the opportunity to get that extra 2-percent interest. The only way to get out of your 6-percent bond is to sell it at current market values and use the money to reinvest at the higher rate.
The only problem with this scenario is that the 6-percent bond is likely to drop in value because interest rates rose. Why? Say that the investor is Bob and the bond yielding 6 percent is a corporate bond issued by Lucin- Muny (LM).
According to the bond agreement, LM must pay 6 percent (called the face rate or nominal rate) during the life of the bond and then, upon maturity, pay the principal. If Bob buys $10,000 of LM bonds on the day they’re issued, he gets $600 (of interest) every year for as long as he holds the bonds. If he holds on until maturity, he gets back his $10,000 (the principal). So far so good, right? The plot thickens, however.
Say that he decides to sell the bonds long before maturity and that, at the time of the sale, interest rates in the market have risen to 8 percent. Now what? The reality is that no one is going to want his 6-percent bonds if the market is offering bonds at 8 percent.
What’s Bob to do? He can’t change the face rate of 6 percent, and he can’t change the fact that only $600 is paid each year for the life of the bonds. What has to change so that current investors get the equivalent yield of 8 percent?
If you said, “The bonds’ value has to go down,” bingo! In this example, the bonds’ market value needs to drop to $7,500 so that investors buying the bonds get an equivalent yield of 8 percent. (For simplicity’s sake, I left out the time it takes for the bonds to mature.) Here’s how that figures.
New investors still get $600 annually. However, $600 is equal to 8 percent of $7,500. Therefore, even though investors get a face rate of 6 percent, they get a yield of 8 percent because the actual investment amount is $7,500.
In this example, little, if any, financial risk is present, but you see how interest rate risk presents itself. Bob finds out that you can have a good company with a good bond yet still lose $2,500 because of the change in the interest rate. Of course, if Bob doesn’t sell, he doesn’t realize that loss.
Historically, rising interest rates have had an adverse effect on stock prices. I outline several reasons why in the following sections. Because our country is top-heavy in debt, rising interest rates are an obvious risk that threatens both stocks and fixed-income securities (such as bonds).
Hurting a company’s financial condition
Rising interest rates have a negative impact on companies that carry a large current debt load or that need to take on more debt because when interest rates rise, the cost of borrowing money rises, too. Ultimately, the company’s profitability and ability to grow are reduced. When a company’s profits (or earnings) drop, its stock becomes less desirable, and its stock price falls.
Affecting a company’s customers
A company’s success comes from selling its products or services. But what happens if increased interest rates negatively impact its customers (specifically, other companies that buy from it)? The financial health of its customers directly affects the company’s ability to grow sales and earnings.
For a good example, consider Home Depot (HD) during 2005–2008. The company had soaring sales and earnings during 2005 and into early 2006 as the housing boom hit its high point (record sales, construction, and so on).
As the housing bubble popped and the housing and construction industries went into an agonizing decline, the fortunes of Home Depot followed suit because its success is directly tied to home building, repair, and improvement. By late 2006, HD’s sales were slipping, and earnings were dropping as the housing industry sunk deeper into its depression.
This was bad news for stock investors. HD’s stock went from more than $44 in 2005 to $21 by October 2008 (a drop of about 52 percent). Ouch! No “home improvement” there. The point to keep in mind is that because Home Depot’s fortunes are tied to the housing industry, and this industry is very sensitive and vulnerable to rising interest rates, in an indirect — but significant — way, Home Depot is also vulnerable.
In 2015, HD was one of the few retail stocks that went up due to the rebounding real estate market. However, as interest rates ticked up at the end of 2015, the real estate industry started slowing down, which means that HD would be vulnerable in 2016.
Impacting investors’ decision-making considerations
When interest rates rise, investors start to rethink their investment strategies, resulting in one of two outcomes:
- Investors may sell any shares in interest-sensitive stocks that they hold. Interest-sensitive industries include electric utilities, real estate, and the financial sector. Although increased interest rates can hurt these sectors, the reverse is also generally true: Falling interest rates boost the same industries. Keep in mind that interest rate changes affect some industries more than others.
- Investors who favor increased current income (versus waiting for the investment to grow in value to sell for a gain later on) are definitely attracted to investment vehicles that offer a higher yield. Higher interest rates can cause investors to switch from stocks to bonds or bank certificates of deposit.
Hurting stock prices indirectly
High or rising interest rates can have a negative impact on any investor’s total financial picture. What happens when an investor struggles with burdensome debt, such as a second mortgage, credit card debt, or margin debt (debt from borrowing against stock in a brokerage account)? He may sell some stock to pay off some of his high-interest debt. Selling stock to service debt is a common practice that, when taken collectively, can hurt stock prices.
Because of the effects of interest rates on stock portfolios, both direct and indirect, successful investors regularly monitor interest rates in both the general economy and in their personal situations. Although stocks have proven to be a superior long-term investment (the longer the term, the better), every investor should maintain a balanced portfolio that includes other investment vehicles.
A diversified investor has some money in vehicles that do well when interest rates rise. These vehicles include money market funds, U.S. savings bonds (series I), and other variable-rate investments whose interest rates rise when market rates rise. These types of investments add a measure of safety from interest rate risk to your stock portfolio.
3. Market risk
People talk about the stock market and how it goes up or down, making it sound like a monolith instead of what it really is – millions of individuals making daily decisions about whether to buy or sell stock. Regardless of how modern our society and economy are, you cannot escape the laws of supply and demand.
A stock becomes more in demand when masses of people want to own it, and its price rises. The price rises more if the supply is limited. If no one is interested in buying a stock, its price drops. Market risk is a function of supply and demand. Stock prices rise and fall on the whims of the market.
Millions of investors buying and selling each minute of every trading day affect the share price of your stock. This fact makes it impossible to judge which way your stock will move tomorrow or next week. This unpredictability and seeming irrationality is why stocks aren’t appropriate for short-term financial growth.
Markets are volatile by nature; they go up and down, and investments need time to grow. Market volatility is an increasingly common condition that everyone has to live with Investors should be aware of the fact that stocks in general (especially in today’s marketplace) aren’t suitable for short-term (one year or less) goals. Despite the fact that companies you’re invested in may be fundamentally sound, all stock prices are subject to the gyrations of the marketplace and need time to trend upward.
Investing requires diligent work and research before putting your money in quality investments with a long-term perspective. Speculating is attempting to make a relatively quick profit by monitoring the short-term price movements of a particular investment.
Investors seek to minimize risk, whereas speculators don’t mind risk because it can also magnify profits. Speculating and investing have clear differences, but investors frequently become speculators and ultimately put themselves and their wealth at risk. Don’t go there!
Consider the married couple nearing retirement who decided to play with their money in an attempt to make their pending retirement more comfortable. They borrowed a sizable sum by tapping into their home equity to invest in the stock market. (Their home, which they had paid off, had enough equity to qualify for this loan.)
What did they do with these funds? You guessed it; they invested in the high-flying stocks of the day, which were high-tech and Internet stocks. Within eight months, they lost almost all their money.
Understanding market risk is especially important for people who are tempted to put their nest eggs or emergency funds into volatile investments such as growth stocks (or mutual funds that invest in growth stocks or similar aggressive investment vehicles). Remember, you can lose everything.
4. Inflation risk
Inflation occurs when the quantity of money is artificially expanded so that too much money is used in exchange for goods and services. Inflation is evident to consumers as higher prices for goods and services.
Purchasing power risk is also known as inflation risk. Simply put, your money doesn’t buy as much as it once did. In 1980, a dollar bought you a sandwich. A few years later, it barely bought you a candy bar. In this case, the value of your investment (a stock that doesn’t appreciate much, for example) may not keep up with inflation.
Say that you have money in a bank savings account currently earning 4 percent (in 2016, the bank interest rate is much lower). This account has flexibility — if the market interest rate goes up, the rate you earn in your account goes up. Your account is safe from both financial risk and interest rate risk. But what if inflation is running at 5 percent? At that point, you’re losing money.
5. Tax risk
Taxes (such as income tax or capital gains tax) do not directly affect your stock investment, but they can affect how much of your money you are able to keep. In order to invest in stocks, you need to understand that taxes take away a portion of the wealth you’re trying to build.
Taxes can be risky because if you make the wrong move with your stocks (selling them at the wrong time, for example), you can end up paying higher taxes than you need to. Because tax laws change so frequently, tax risk is part of the risk-versus-return equation, as well. It pays to gain knowledge about how taxes can impact your wealth-building program before you make your investment decisions.
6. Political and governmental risk
Politics and government policies (such as taxes, laws, and regulations) would be the pond for companies. Similarly, government policies and politics can kill companies, just as toxic ponds kill fish.
It is important to be aware of political and governmental risks if you own stock in a company that is exposed to them. The mere introduction of a new law or regulation can send some companies into bankruptcy. Other companies can increase sales and profits with the help of a new law.
What if you invest in companies or industries that become political targets? You may want to consider selling them (you can always buy them back later) or consider putting in stop-loss orders on the stock.
For example, tobacco companies were the targets of political firestorms that battered their stock prices. Whether you agree or disagree with the political machinations of today is not the issue. As an investor, you have to ask yourself, “How do politics affect the market value and the current and future prospects of my chosen investment?”
Keep in mind that political risk doesn’t just mean in the good ol’ US of A; it can also mean international political risk. Many companies have operations across many countries, and geopolitical events can have a major impact on those companies exposed to risks ranging from governmental risks (such as in Venezuela in 2015) to war and unrest (as in the Middle East) to recessions and economic downturns in friendly countries (such as in Western Europe).
If international investing interests you and you see it as a good way to be more diversified (beyond the U.S. stock market), then consider exchange-traded funds (ETFs) as a convenient way to do it.
7. Personal Risk
Frequently, the risk involved with investing in the stock market isn’t directly related to the investment; rather, the risk is associated with the investor’s circumstances.
Suppose that investor Ralph puts $15,000 into a portfolio of common stocks. Imagine that the market experiences a drop in prices that week, and Ralph’s stocks drop to a market value of $14,000.
Because stocks are good for the long term, this type of decrease usually isn’t an alarming incident. Odds are that this dip is temporary, especially if Ralph carefully chose high-quality companies. Incidentally, if a portfolio of high-quality stocks does experience a temporary drop in price, it can be a great opportunity to get more shares at a good price.
Over the long term, Ralph will probably see the value of his investment grow substantially. But what if Ralph experiences financial difficulty and needs quick cash during a period when his stocks are declining? He may have to sell his stock to get some money.
This problem occurs frequently for investors who don’t have an emergency fund to handle large, sudden expenses. You never know when your company may lay you off or when your basement may flood, leaving you with a huge repair bill. Car accidents, medical emergencies, and other unforeseen events are part of life’s bag of surprises — for anyone.
You probably won’t get much comfort from knowing that stock losses are tax-deductible — a loss is a loss. However, you can avoid the kind of loss that results from prematurely having to sell your stocks if you maintain an emergency cash fund.
A good place for your emergency cash fund is in either a bank savings account or a money market fund. Then you aren’t forced to prematurely liquidate your stock investments to pay emergency bills.
8. Emotional risk
How does emotional risk relate to stocks? Since investors are human, emotions are important risk factors. Investment success depends on logic and discipline, but even the best investors can let emotions take over and lose money. When investing in stocks, you’re likely to be distracted by three main emotions: greed, fear, and love. You need to understand your emotions, as well as the risks they may expose you to. You don’t need a stock investing book if you become too attached to a sinking stock – you need a therapist!
Paying the price for greed
In 1998–2000, millions of investors threw caution to the wind and chased highly dubious, risky dot-com stocks. The dollar signs popped up in their eyes (just like slot machines) when they saw that Easy Street was lined with dot-com stocks that were doubling and tripling in a very short time. Who cares about price/earnings (P/E) ratios when you can just buy stock, make a fortune, and get out with millions?
Unfortunately, the lure of the easy buck can easily turn healthy attitudes about growing wealth into unhealthy greed that blinds investors and discards common sense. Avoid the temptation to invest for short-term gains in dubious hot stocks instead of doing your homework and buying stocks of solid companies with strong fundamentals and a long-term focus
Recognizing the role of fear
Greed can be a problem, but fear is the other extreme. People who are fearful of loss frequently avoid suitable investments and end up settling for a low rate of return. If you have to succumb to one of these emotions, at least fear exposes you to less loss.
Also, keep in mind that fear is frequently a symptom of a lack of knowledge about what’s going on. If you see your stocks falling and don’t understand why, fear will take over, and you may act irrationally. When stock investors are affected by fear, they tend to sell their stocks and head for the exits and the lifeboats.
When an investor sees his stock go down 20 percent, what goes through his head? Experienced, knowledgeable investors realize that no bull market goes straight up. Even the strongest bull goes up in a zigzag fashion.
Conversely, even bear markets don’t go straight down; they zigzag down. Out of fear, inexperienced investors sell good stocks when they see them go down temporarily (the correction), whereas experienced investors see that temporary downward move as a good buying opportunity to add to their positions.
Looking for love in all the wrong places
Stocks are dispassionate, inanimate vehicles, but people can look for love in the strangest places. Emotional risk occurs when investors fall in love with a stock and refuse to sell it, even when the stock is plummeting and shows all the symptoms of getting worse.
Emotional risk also occurs when investors are drawn to bad investment choices just because they sound good, are popular, or are pushed by family or friends. Love and attachment are great in relationships with people but can be horrible with investments. To deal with this emotion, investors have to deploy techniques that take the emotion out. For example, you can use brokerage orders, which can automatically trigger buy and sell transactions and leave out some of the agonizing. Hey, disciplined investing may just become your new passion!
One of the fundamental trade-offs that an investor will make is risk vs. return. Generally speaking, the higher the risk, the greater the possibility of good returns. In 1998, Amazon was a pretty high-risk investment. While it had potential, major bookstores like Borders and Barnes & Noble dominated the space.
Amazon was on shaky ground at the time, and another company could have come in and competed successfully for online book sales. That never happened, and Amazon ended up dominating book sales and expanding widely across retail and into cloud computing. That risk has translated into massive returns. A $10,000 investment in 1998 would be worth more than $1 million today.
But hindsight is 20/20. Today, there are similar opportunities all around us, but it’s hard to know which ones will end up being successful over the long term. If you are an aggressive investor, part of your job will be estimating which companies are the best bets for the future.
These examples serve to illustrate why a diversified portfolio is essential.
There are a few time-tested strategies that have been developed that help manage risk. They even minimize, as much as possible, the kinds of risks that you will face that are completely out of control.
That could include anything from a terrorist attack to interest rate changes.
These strategies are simple and easy to understand. The problem is that in practice, many investors fail to follow them, and instead let their decision-making be guided by emotions. You might end up following that path as well. However, we are going to give you the tools you need to avoid it. It’s up to you whether you utilize them or not.
Learn more about the best ways to minimize investment risks.