What are the most common risks when investing in the stock market? (2024)

A security can be more or less volatile and subject to price fluctuations that deviate from its expected return.In portfolio theory, diversification can be an efficient tool to reduce the volatility of a portfolio. By mixing different asset classes, which have low or negative correlation to one another, the overall portfolio volatility can be lower than the weighted average volatility of its components.

The rapid evolution of technology can render certain sectors obsolete, while boosting others. Investors can counteract this risk by staying informed about global technological trends and adjusting their portfolios accordingly, potentially benefiting from sectors poised for growth due to technological advancements.

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Try to avoid illiquid stocks if you are a trader. Hence, a long-term investor might do invest in illiquid assets. A trader should look for liquid stocks.

This risk in the stock market often correlates with market depth and investor behaviour. A stock's liquidity can significantly fluctuate based on corporate news or sector specific developments, impacting the ease of trade. An effective strategy to mitigate this risk is to monitor news and trends closely, which may signal changes in liquidity, enabling investors to make timely decisions before major liquidity shifts occur.

Credit spread is the market mesure of credit risk, which is the pickup in yield for a credit security (corporate bond for example) compared to its benchmark.Credit spreads incorporate the market expected probability of default and recovery rate for a particular investment.Additionally, in the event of a default, the value of your investment does not necessarily go to zero. Depending on the seniority of your claim and the allocation of collateral, a percentage of your invested principal can be recovered.Diversification is key when investing in credit securities. A fixed income portfolio can recover from the default of a borrower, given its exposition is not too concentrated.

Credit risk is intrinsically linked to the financial stability of companies in which one invests. Beyond mere credit ratings, investors can mitigate credit risk by analysing industry trends and economic cycles that might impact a company's revenue and debt management capacity. This approach aids in identifying companies with robust business models capable of weathering economic downturns, thereby reducing potential credit risk exposure.

Over the long term, equities have proved to be very effective securities to contrast the eroding power of inflation, and deliver positive real returns. In my experience, what investors are mostly worried about is inflation risk over the shorter-term, especially when inflation volatility is high, driven for instance by a supply side shock (e.g., war) and increasing energy costs. Over the shorter term, investors should look for high inflation beta assets, to protect their portfolio from inflation risk. These are assets whose return moves close or higher than the rate of inflation. Commodities, for instance, tend to have inflation betas close to 2, making them very effective securities for hedging unexpected inflation.

Inflation risk affects the real returns of investments. It's important to understand that different sectors react diversely to inflationary pressures. For instance, industries like real estate often benefit from inflation, whereas others may suffer. A nuanced approach to inflation risk involves investing in sectors that historically demonstrate resilience or growth during inflationary periods, thus potentially offsetting the eroding effects of inflation on investment returns.

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Companies which have a strong pricing power can adapt their pricing to offset the inflation impact on their costs.Dividend-paying stocks, which grow their earnings per share and increase their dividend distributions while possessing a strong pricing power, are one of the investments, which shield returns from inflation in the long run.Teasury Inflation-Protected Securities (TIPS) offer higher returns when realised inflation is higher than the market implied expected inflation, and lower returns when realised inflation is lower than expected inflation.Thus, having TIPS in your portfolio before any sign of strong inflation can be a good hedge for a potential inflation shock, but buying them too late or too early is counterproductive.

Behavioral risk has gained increasing recognition in the finance world, especially post the 2008 financial crisis, which underscored the impact of human psychology on financial markets. Today, with volatile markets and a deluge of information, understanding and managing behavioral risk is more relevant than ever.One must not underestimate the difficulty of overcoming deeply ingrained cognitive biases. Further we must address the potential limitations of a disciplined and systematic approach in a rapidly changing market environment.

Overconfidence is the Most Common and Costly Bias of Investors*********************The wisdom of crowds prevents the vast majority of investment professionals from outperforming broad market indices. This law dictates that the collective pricing estimates embedded in millions of trades is much more likely to be accurate than the individual guess of an individual investor (assuming market manipulation and insider trading is not in play). Most investors refuse to recognize this reality. Even those who succeed in the short-term often mislabel their performance as skill rather than luck. This being the case, the greatest risk to investors is falling victim to the belief that they can outsmart the market.

Behavioral risk is a subtle yet significant aspect of finance, exposing investors to their own psychological biases. Unlike other risks that can be communicated, behavioral risk is more challenging to detect and manage. When investing, individuals confront their own beliefs and biases, testing their convictions, particularly in volatile markets. Without a clear plan for exiting unsuccessful investments, an investor may feel directionless. The temptation to change the adjust stop-loss parameters, or the absence of them, leaves one vulnerable to emotional decisions. Establishing exit strategies and stop-loss parameters is essential to mitigate such risks and maintain investment discipline.

Here are some other risks to consider: 1️⃣ Interest Rate Risk:This affects stocks sensitive to rate changes, and can be managed by diversifying into less affected sectors. 2️⃣ Currency Risk:This is significant in international investments, and requires strategies like currency hedging to mitigate exchange rate volatility. 3️⃣ Political Risk:Stemming from governmental changes or geopolitical tensions, can be reduced by geographic diversification. 4️⃣ Sector-Specific Risk:This risk, linked to industry-specific factors, suggests the need for a portfolio diversified across various industries to minimise exposure.

In addition to all the risks mentioned, one more risk is the opportunity cost risk. In the stock markets, the risk of opportunity cost arises when you invest in one stock, potentially missing out on gains from another that might have performed better. While this can only be judged in hindsight, there are two ways to minimize the risk of opportunity cost:1. Price Stop Loss - This is the maximum loss that you are willing to take on a particular stock and you sell the stock when it falls below your stop loss.2. Time Stop Loss - This is the maximum time that you are willing to hold a stock without any significant gains. This might range from one week to one year or even more depending on the horizon or risk appetite of the investor.