Here are 7 common types of risk involved in stocks that every investor in equity should know:
1. Market risk
This is also called as systematic risk and is based on the day-to-day price fluctuation in the market.
The market index Sensex and Nifty goes up and down throughout the day. And many a time, it may affect the returns from a stock. For example, if the stock market is going down at a time, then it might pull down the prices of even some good stocks.
2. Business Risk
The second type of stock risk comes from the business. This risk can be escalated if the business is not doing well. Reasons like the failure of management, poor quarter-by-quarter results, or your misjudgment in picking a company come under business risk.
However, you can mitigate this risk by diversification. The chance of one business not performing well is ‘high’ compared to 5 such companies. Hence, if you are keeping 5 stocks in your portfolio, instead of one, you can reduce the business risk.
3. Liquidity Risk
Before investing in a stock, you should definitely check how solvent the company is? Companies with high debts may find it hard to pay their bills. Many times, they might even cut the dividends or in the worst case, may go bankrupt. Liquidity risks are involved in all businesses.
4. Taxability Risk
The government changes taxes all the time and hence taxes may increase or decrease in the particular industry where you invested. The change in taxation can affect the stock price.
Further, there are few industries which are taxed comparatively higher to other and hence, their net profit after tax may be less. Further, as taxation is controlled by the government, there is not much that the management or the investors can do.
5. Interest Rate Risk:
The open market or global equity market interest rates changes time to time. And this can positively or adversely affect the stocks depending on the direction in which the interest rate is moving. For example, when the interest rates are high, a company might find it difficult to borrow money (at high rates). Further, the bond market declines as the interest rate increases, which may also affect the corporate bonds.
6. Regulatory Risks:
There are a number of regulations imposed in the different industry which must also be termed as the risk involved in stocks. For example, Cigarettes, telecommunication, beverages, pharmaceutical and few other industries are highly regulated.
If a pharmaceutical company loses any of its drug manufacturing right/permission because of a regulatory effect, then it will definitely affect the company’s profit and hence, the stock price.
7. Inflationary Risk:
With an increase in inflation, the price of raw material will increase, which can affect the production cost. Many companies involved in commodities like oil, soya bean etc are affected a lot by inflationary risk.
Further, for few industries, the inflation rate is too high. For example, education and healthcare.
The tuition fee for schools and colleges are increasing at a very fast rate. Although, it might sound good in the short term as these industries will make money from the inflated price. However, for the long run, it might have an adverse effect on retention of the customers.
Bonus: Few other risks
Beside the above mentioned 7 risks involved in stocks, here are few other risks that are worth mentioning.
Social and political risk: Many companies face problem due to social and political risks. For example, Tata Motors shifted its Tata-Nano plant from West-Bengal to Sanand- Gujarat because of political reason, which cost a lot of money to Tata.
Credit Risk: The risk that the company who issued the bond won’t be able to pay the interest or repay the principal at maturity and may find it hard to buy/sell goods.
FII/DII investments: The investment by big players can also be counted as the risk involved in stocks. If the foreign direct investment/ domestic investment decreases in a company, and they start selling their stocks, then it might adversely affect the share price of that company.
Currency and exchange rate risk: Many companies who deals across nations or the companies involved in import/export may face a problem with increased dollar price. Therefore, the currency and exchange rate fluctuations might increase risk in these companies.
There are a number of risks involved in stocks. Nevertheless, if you understand the basic concept behind the risk involved in stocks, you can control the amount of risk you want to take.
Moreover, the risk is reduced over the long-term. A short-term fluctuation won’t hurt your portfolio in the long run. Further, most of the short-term market fluctuations, political, or social risks will be nullified while investing for duration of 10-15 years.