Risks to consider when investing
Investing your money in the stock market always comes with a degree of risk. Risk trade-off theory states that the higher the potential return, the higher the risk. When growing your money through a cash-secured savings vehicle like a fixed deposit, risk is low, as your capital is guaranteed. The major difference when investing in stocks is that capital is not guaranteed and risk needs to be managed through diversification. The below outlines all the risks associated when investing in the stock market.
1. Market risk
Refers to the risk of your investment declining in value because of certain economic developments or other events that affect the entire market.
Market risk can be broken down into three categories as follows:
Equity risk is the risk of the share price dropping. Share prices typically fluctuate in price based on supply and demand. The higher the demand, the lower the supply. The higher the price, the lower the demand, and the higher the supply, the lower the share price will be. Market sentiment can impact the demand of a share and affect investors both favourably and unfavourably.
Interest rate risk
Interest rate risk applies to debt. An increase in interest rates can impact company performance and decrease the share price. Therefore, this also decreases the market value of bonds and other similar fixed instruments. A change in interest rates can impact investment returns.
Currency risk applies when you own foreign investments. It is the risk of losing money because of an unfavourable movement in the exchange rate. For example, if you own US shares, the strengthening of the rand will be unfavourable to you, whereas, the weakening of the rand will result in higher profits, as your dollars are worth more in rands.
2. Liquidity risk
Liquidity risk is when you are unable to sell your investment due to low demand for that specific asset. There are certain less popular investments which can be harder to sell. To sell the investment, you may need to accept a lower price. In some cases, such as exempt market investments, it may not be possible to sell the investment at all.
3. Concentration risk
Refers to the risk of loss because your money is concentrated in one investment or type of investment. Concentration risk can be high when invested in a single stock or overexposure to a sector or industry. This is known as putting your eggs in one basket. This risk is managed through diversification and ensuring concentration and portfolio risk are spread through the inclusion of multiple assets in a portfolio.
4. Credit risk
Credit risk relates to the issuer of your investment not honouring their obligations. Simply not receiving what you were promised when investing. A government bond pays regular coupon payments. Should the government default on these coupon payments, you would not receive your return. The same can be said about companies and preference shares. Credit risk can be evaluated by looking at the credit rating. A credit rating of AAA indicates the lowest credit risk.
5. Inflation risk
The risk of a loss in your purchasing power because the value of your investments does not keep up with inflation. Keeping up with the cost of living is essential when looking to maintain and grow wealth. Putting all your money in low-risk cash instruments could result in your returns being lower than the increase cost of living, meaning your money is losing value each year. Investing in stocks is one way to try and overcome this through higher potential returns. Certain companies charge customers more each year for products to keep up with inflation.
6. Horizon risk
The risk that your investment horizon may be shortened because of an unforeseen event, for example, the loss of your job. This may force you to sell investments that you were expecting to hold for the long term. This can result in selling those investments at an unfavourable time or not giving those assets the time needed to perform. That is why it is essential to have three months emergency savings put away.
Although investing comes with a degree of risk, this risk can be managed through diversification and fundamental analysis of the investments chosen. Ultimately, this can be done through the inclusion of multiple assets in a portfolio, so overall risk can be spread and ultimately reduced. Risk needs to be in line with long-term goals. The higher the potential risk of an investment, the higher the potential return needs to be. Successful investing is about managing risk correctly and ensuring investments are made in a balanced manner.