Risks Of Investing In The Stock Market
One of the biggest risks when it comes to investing in the stock market, is financial risk. Make a poor investment and you could lose a significant amount of your money, or worse, all of it! Take the dot-com bubble as an example. During 1999 internet stocks were seen as a quick and easy way to make money due to the rapid growth of the companies which those stocks represented.
In some cases, growth rates went as high as 70%, and so for many people, internet stocks were seen as a far better investment option than savings accounts which only offered a measly 1-7% rate of interest. Of course, as we know today, the record growth rates that occurred in 1999 did not last for very long, and when the value of those stocks crashed, so did the hopes and dreams of the people who had invested in them.
The biggest risk of investing in the stock market, therefore comes as a result of companies going bankrupt as we saw when the dot-com bubble burst. But not all loses are as dramatic as this, as any company that is doing poorly financially can experience a rapid decline in the value of their stock, which, of course, also means a decline in the value of your investment.
In this article, we are going to be looking at some of the main risks that are associated with investing in the stock market. Why is this important? Because once you become aware of what risks there are, you should, in theory, then be able to avoid those risks, and by doing so, safeguard the integrity of your investments.
So as a gentle introduction, lets start by looking at some of the things that you should be doing and what lessons can be learnt from the collapse of the dot-com bubble. After which, we shall explore some specific risks and then discuss some risk reduction measures that you can incorporate into your investment activities.
Lessons From The Dot-Com Crash
To reduce your risk of financial loss in the stock market, the most important thing that you should do before making an investment, is to ensure that you carry out an adequate amount research. Although this may sound like an obvious step, you would be surprised at just how many people jump on an investment because they have heard that it is a good bet.
Perhaps the best example of this type of herd mentality to investing occurred in the late 1990s, when many investors who invested in internet stocks ignored the obvious financial risk because everyone else seemed to think that they were a good investment.
After the dot-com bust, internet and tech stocks littered the stock market graveyard. Simply because investors failed to see the risks associated with investing in companies which didn’t have a proven track of results, such as of profit and sales.
On the other hand, wiser investors who took the time to research such companies, decided to put their money elsewhere. Their research indicated to them that many internet companies had high debt, low earnings and lots of competition.
All of these factors are considered to be high risk when it comes to long-term stock market investing, and so by doing the research beforehand, these investors saved themselves from losing millions.
The lesson we learn from this is that when you invest in the stock market, but invest in companies which do not have a proven track record, you are not investing, you are speculating. In other words, you are gambling with your money, and everyone knows that gambling is a very risky activity to engage in!
This however, does not mean to say that you should never invest in new companies. Some investors for example, specifically look for new start-ups because they hold the greatest potential for growth and the greatest potential for making a quick profit.
But, most of these investors, at least the wise and experienced ones, recognize that such investments are inherently risky, and so they only invest in companies which they have spent the time to research and for which they can afford to take a loss on if their investment doesn’t work out.
Be Careful When Receiving Investment Advice
Another important lesson that we learn from the dot-com bubble, relates to who you get your information from. Many investors who invested in internet companies for example, did so because popular stock market analysts and media sources were reporting them as being a safe and a profitable investment.
The result was that many investors who had not invested in the stock market before, decided to buy stocks based on the advice that they were getting from the “experts”. Some even did so solely on the recommendations of their friends!
Before long, it seemed like everyone was investing in internet stocks, and the ensuing buying frenzy caused people to leave their senses behind and go along with the crowd rather than with their own personal judgement.
So the lesson is simple. When doing stock market investing, get your information from multiple sources and don’t rely on just one person or one source. Second, don’t invest in something just because everyone else is investing in it, especially, if you haven’t done the research beforehand!
Remember The Basics
If you remember nothing else about stock market investing, then remember this. The most basic rule when it comes to making successful long-term investments, is to invest in companies which are making money and have a positive growth curve (i.e. are predicted to make more money in the future).
If a company is making money, and are predicted to continue doing so, when you invest in them, then over time the value of your stocks will go up and you will make money.
If however, a company is not making money, or is not profitable, then investing in them is generally a bad idea and one that will most likely lose you money.
These two principles are known as the fundamentals, and successful investors will always make sure that the fundamentals are sound before they even consider making an investment.
Interest Rates Risks & The Stock Market
Rising and falling interest rates are of particular concern to stock market investors, as historically, rising interest rates have had a negative effect on the value of stocks. The reason for this is simple, as any company which carries a large amount of debt, or will need to borrow money in the future, will have to pay more for that money because the cost of borrowing it increases.
The long-term effect of this is that the profitability of the company will be reduced, as will its ability to grow. When a company’s profits drop, its stock value will also drop. This is why it is important to take into account how much money a company is predicted to make and the level of debt that it is in.
The less money a company is making, and the more debt that it is in, the more vulnerable it is to fluctuating interest rates and the riskier of an investment it becomes.
Customers
The success of a company is largely dependent upon its ability to sell the products or services it specializes in. Rising interest rates can therefore affect a company by negatively impacting its customers. This may include the general public or other companies which buy from it.
What this means is that the health of a company is also affected by the health of its customers, because this affects how much a company will grow and how much it will earn. All of which then affect how much the company is worth on the stock market.
A good example of how rising interest rates can have a negative impact on the stock value of a company, can be found with Cisco Systems in 2000. A large part of Cisco Systems’ sales went to the telecommunications industry. Cisco’s profit was therefore largely dependent upon the health of those customers in that industry.
During this time however, the debt of the telecom industry rose to around $700 billion, which eventually resulted in telecom companies buying less from Cisco and buying less overall in general. The effect of this was that Cisco’s profits shrank, and from March 2000 to March 2001, Cisco’s stock price fell by nearly 70 percent.
Interest Rates & Financial Investors
Interest rate fluctuations can cause investors to change their investment strategy. If interest rates go up, investors may do one of two things:
1) Sell Shares
Any shares that are at risk of being negatively affected by rising interest rates, may cause an investor to sell them. Some interest sensitive industries include electric utilities, real estate and the financial sector. Generally speaking, rising interest rates negatively affect industries in these sectors, whilst falling interest rates give them a boost.
2) Change Type Of Investment
Investors can either favor having an increased amount of current income from their investments, or wait for their investment to grow in value over time and then sell when its value has increased. Investors who are looking for increased current income, tend to prefer higher interest rates and so may switch from stocks to bonds or a bank certificate of deposit (CD).
The Risk Of Inflation
Just as rising interest rates can pose a risk to your investments, so too can inflation. Inflation results in everything which you normally buy becoming more expensive than it used to be because the value of your money has decreased. So if it cost you $1 to buy a loaf of bread for example, with inflation it may now cost you $2.
So as a result of inflation, things become gradually more expensive and your purchasing power (the amount of things you can buy with your money) also begins to decline. When it comes to the investments that you make, the risk you face is that the value of your investments may not be able to keep up with the rate of inflation.
For example, if you have money in a bank account earning 3% interest, then you are safe in terms of having minimal financial risk. If however, the rate of inflation goes up to 4%, then you will be losing money because your money is losing value faster than interest is adding to its value.
With any type of investment that you make, you must therefore always remember to take interest and inflation into consideration, especially when you are making a long-term investment over a period of decades.
Cash Flow
A less obvious risk that is often overlooked when investing in the stock market, is that of personal cash flow. For instance, suppose that you invest $10,000 in the stock market. The value of your investment may decrease in the short-term, but if you are investing for the long-term, then this won’t affect you.
What will affect you, is if you then need that money for something else, but because your money is tied up in the stock market, you find yourself short of cash. If this occurs, you may then have to sell some of your stocks, which could result in a net loss if you sell for an amount less than what you originally paid. Of course, an alternative strategy to selling stocks is to take out a short-term loan, although in most cases, this is likely to lead to an even bigger loss.
This scenario is a common one that is experienced by many investors who decide to invest in the stock market, but don’t set aside enough money to support themselves as their investment matures. So if you are thinking of buying stocks, make sure that you have a detailed picture of your future cash flow situation so that you can keep your investment as a long-term investment and will not be forced to break into it when things get tough. A good way to do this is with an emergency fund.
An emergency fund is simply money that you keep saved away in a savings account for the times when your primary source of income gets cut off. This may be because you lose your job or because you become unable to work due to illness or injury.
Whatever the reason, having some money set aside which you know that you can draw upon in times of need, will help to protect your current investments and provide you with a buffer period in which to secure another source of income for yourself. The larger your emergency fund is, the greater the financial protection that it will provide you with.
The Emotional Risk Of Investing Money
In addition to the financial risks that are involved with stock market investing, there are also various emotional risks which you should take into consideration before you buy or sell any stocks. Emotions are important in terms of investing, because the actions you take are largely driven by how you feel about something rather than what you think about it.
The trouble is, these emotions can cloud your judgment and cause you to make unwise investment decisions that you later regret. When it comes to stock market investing, there are three emotions that you should pay particular attention to: greed, fear and love.
Greed
During the late 90s, many people invested in the stock market because they saw internet companies as a quick and easy way to make money. The result was that many people invested in companies without first looking to see if they were indeed a good long-term investment.
Since everyone seemed to be buying internet stocks, it soon became a common perception that internet stocks could make you millions, but only if you bought them now and before it was too late. Unfortunately, for many people, this turned out to be a very bad move, as during the dot-com bust they lost virtually all their money.
The moral of the story is to always keep your focus on the fundamentals. Look to see if a company is making money, if it is in debt and its projected future earnings. If the fundamentals are sound then look at how much money it could make you, rather than being blinded by the money first and then later having to regret making a bad investment decision.
Fear
Fear is another powerful emotion that can drive investors to make unwise purchasing decisions.
Fear can come from fearing that you may lose out on an investment opportunity if you don’t buy now, fear of not being able to financially support yourself if your investments don’t go as well as planned or fear that you should sell now before your investments lose any more value.
Be aware of fear, because like greed, fear can cloud your judgment and cause you to act irrationally. So don’t make important decisions when you are in a state of fear, and if possible, get someone else’s view on the situation as they will be able to see things from a clearer perspective.
Also, if you are in the stock market for the long-term, then be aware that the stock market has its ups and downs, and that historically, your investments will increase in value over time if you stick with them for long enough.
Love
Strangely enough, some people become attached to their stocks, and will continue to hold onto them even when the value of their stocks are decreasing and future indications suggest that the situation will get worse.
Emotional attachment to a stock is most likely to occur when you feel personally invested in a company, for example, because you were pushed into an investment or were given some stocks by family or friends.
The key to successful investing is not to get attached to your stocks, but rather, to see them for what they are, an investment vehicle. When your stocks are doing well and you think that they will continue to do well, hold onto them. When you think that they are doing poorly and will continue to do poorly, sell your stocks.
Reducing The Risk Of Stock Market Investing
So far in this article, we have examined some of the main risks associated with stock market investing. Being aware of these risks should help to make you a wiser investor and one who is less vulnerable to the many dangers that the stock market holds.
In the rest of this article, we shall provide a list of risk reduction strategies that you can use to more safely invest your money. It is important to remember though, that none of these strategies will completely eliminate risk, they will only reduce it. So you still need to be very careful about what investments you make and who you choose to invest in.
Know Your Investments
If you are going to be investing your money in a company, you should know as much as you can about it before you invest. This is something that is practiced by Warren Buffett, someone who is regarded as one of the most successful investors of all time.
Despite this sounding like obvious advice, which it is, you would be surprised at how little some people know about the investments they make. I have come across some people for example, who know more about their favorite sports team than they do about the companies with whom they are invested in. Needless to say, such investments are very rarely successful.
At a minimum, make it your aim to know how the stock market works, the factors that affect stock value and how to analyze a companies current and future earnings. This should put you in a good position when it comes to selecting successful stocks.
Remember, if you don’t know much about the stock market, don’t buy stocks! Educate yourself first, then buy!
Play The Stock Market For Free
If you have never invested in the stock market before, then a good risk free way to practice is to pretend to buy stocks which you think would make a good investment. If the value of your stocks goes up, then you are probably ready to invest with real money.
But if your stocks do poorly, then you should go back and do a bit more research to learn the factors that affect stock value before making your next investment.
Get Rid Of Debt
Whilst you may be able to make some money by investing in the stock market, if you are currently in debt, then you could be losing more money than you make. So get yourself out of debt first, and then buy stocks.
Major debts include credit card debt and personal loans, both of which tend to have very high interest rates that result in you paying back much more than you originally borrowed. So if you have such debts, pay them off first because the interest on them will literally eat you alive!
Is Your Job Secure?
As was mentioned previously, when you invest in the stock market your money will be tied up in those stocks for a certain period of time. This means that during this period, you will need some other money to support yourself with.
For most people, their main source of income will be their job and so it is important to ensure that your job is secure for the long-term. If there is any chance of you losing your job in the immediate future, then unless you have a lot of money tucked away in reserve, you would be better off waiting until you find a secure job before you go ahead and invest in the stock market.
Today however, long-term job security tends to be relatively rare, so you may want to compensate for this by saving up an emergency fund.
Have Adequate Insurance
Insurance will protect you against large financial losses. So at a minimum, you should have health insurance and disability insurance first before you buy any stocks.
If you don’t have such major forms of insurance, and you were to suffer a large financial loss, you could then find yourself in a very difficult financial situation that results in the loss of all your investments and even your home.
Diversify Your Investments
Diversification is a strategy which many investors use to protect themselves against circumstances which could reduce the value of their investments. There are three main ways that you can do this when investing in the stock market:
Don’t Buy Only One Stock Type
If you only buy one type of stock you may make a lot of money, but the risks in doing so will be very large. By purchasing several different types of stocks however, you will protect yourself from suffering one big loss and will also find it much easier to recover from setbacks.
Don’t Purchase Stocks From Only One Industry
Some industries perform better in the stock market than others, and so to some, it may seem like a good idea to invest only in those industries. However, it is generally recommended that unless you are an expert in a particular industry, that it is better to buy stocks from several different industries to protect yourself should one industry start to experience a downturn.
Don’t Buy Stocks Only
Whilst the stock market can be a great way to make money in the long-term, you shouldn’t only invest in it and nothing else. Who knows what the future holds in store for the stock market and the stocks you have bought?
So to protect yourself financially, spread your money out into bonds, bank accounts, treasury securities, real estate and precious metals such as gold and silver.
Note: Some financial experts do not agree with the advice of diversifying your investment portfolio in terms of the stock selections that you make. Some argue, that providing you have a detailed level of understanding in a particular area, that you can invest in it whilst still minimizing the risk that you are exposed to.
