The Major Types of Risk for Stock Investors
Risk is part of investing
Investing in stocks is a risky business. There are some risks you have some control over and others that you can only guard against. Thoughtful investment selections that meet your goals and risk profile keep individual stock and bond risks at an acceptable level.
However, other risks are inherent in investing you have no control over. Most of these risks affect the market or the economy and require investors to adjust portfolios or ride out the storm.
Here are four major types of risks that investors face and some strategies, where appropriate for dealing with the problems caused by these market and economic shifts.
- Economic Risks: One of the most obvious risks of investing is that the economy can go bad. Following the market bust in 2000 and the terrorists’ attacks in 2001, the economy settled into a sour spell. A combination of factors saw the market indexes lose significant percentages. It took years to return to levels close to pre-9/11 marks, only to have the bottom fall out again in 2008-09.
For young investors, the best strategy is often to hunker down and ride out these downturns. If you can increase your position in good solid companies, these troughs are often good times to do so. Foreign stocks can be a bright spot when the domestic market is in the dumps if you do your homework. Thanks to globalization, some U.S. companies earn a majority of their profits overseas.
However, in a collapse like the 2008-09 disaster, there may be no truly safe places to turn. Older investors are in a tighter bind. If you are in or near retirement, a major downturn in stocks can be devastating if you haven’t shifted significant assets to bonds or fixed income securities.
- Inflation: Inflation is the tax on everyone. It destroys value and creates recessions. Although we believe inflation is under our control, the cure of higher interest rates may at some point be as bad as the problem. With the massive government borrowing to fund the stimulus packages, it is only a matter of time before inflation returns.
Investors historically have retreated to “hard assets” such as real estate and precious metals, especially gold, in times of inflation. Inflation hurts investors on fixed incomes the most since it erodes the value of their income stream. Stocks are the best protection against inflation since companies can adjust prices to the rate of inflation.
A global recession may mean stocks will struggle for a protracted amount of time before the economy is strong enough to bear higher prices. It is not a perfect solution, but that is why even retired investors should maintain some of their assets in stocks.
- Market Value Risk: Market value risk refers to what happens when the market turns against or ignores your investment. It happens when the market goes off chasing the “next hot thing” and leaves many good, but unexciting companies behind. It also happens when the market collapses - good stocks, as well as bad stocks, suffer as investors stampede out of the market.
Some investors find this a good thing and view it as an opportunity to load up on great stocks at a time when the market isn’t bidding down the price. On the other hand, it doesn’t advance your cause to watch your investment flat-line month after month while other parts of the market are going up.
Don’t get caught with all your investments in one sector of the economy. By spreading your investments across several sectors, you have a better chance of participating in the growth of some of your stocks at any one time.
- Being Too Conservative: There is nothing wrong with being a conservative or careful investor. However, if you never take any risk, it may be difficult to reach your financial goals. You may have to finance 15 to 20 years of retirement with your nest egg. Keeping it all in savings instruments may not get the job done.
If you learn about the risks of investing and do your homework on individual investments, you can make decisions that will help you meet your financial goals and still let you sleep at night.