Understanding and Reducing 5 Risks of the Stock Market

Understanding and Reducing 5 Risks of the Stock Market

When it comes to investing in the stock market, you might think that the only risk you face is the risk of losing money. While you do risk losing money, there are many risks within the market that leads an investor to make or lose money. Because of this, it is critical that you understand the risks of the stock market.

By knowing the various risks, you can create a plan and take a strategic approach to investing that will allow you to reduce or eliminate most risk. But you cannot eliminate all risk from investing in the stock market.

However, being proactive and reducing all of the risks can lead to less volatility and more growth over the long term. Let’s look at 5 risks of the stock market.

5 Risks Of The Stock Market

#1. Market Risk

This risk is what you face when you invest in the Motley Fool latest stock pick. 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.

But since you want to invest in the stock market, not investing isn’t an option. Because of this, you have to accept the risk of the market as a whole.

Luckily though, there are other risks you have some control over.

#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. For example, look at Chipotle stock. This stock was riding high and many investors felt it was a great investment.

But then reports of multiple E. Coli outbreaks occurred and the stock price plummeted. It was only recently the company got things back on track.

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

Inflation causes the value of money to decrease over time. As a result, investors need to earn a decent return to stay ahead of inflation and grow their wealth.

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.

To do this, we turn again to investing in a well-diversified portfolio. 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. This is 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.

Let’s 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 three or four 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:

  • One-year bond
  • Five-year bond
  • 10-year bond
  • 20-year bond

When the one-year bond matures, you reinvest that money back into another one-year bond. When the five-year bond matures, you reinvest that money into another five-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

There are 5 risks of the stock market. While there are more risks you may face, these 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.

Jon Dulin

About the Author:

Jon writes for Money Smart Guides, a personal finance blog that helps readers get out of debt and start investing for their future. He has been investing since he was 16 and has learned a lot through the years. He uses these investment lessons to help him be a more successful investor today. Also check out his contributions to Compounding Pennies and ETF Trends.

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