When you buy stocks, you have to take many things into consideration.
One of the biggest things you need to carefully think about is the amount of risk you are taking on when investing in stocks.
Stocks come with all types of risks. You’ll come across risky stocks and not so risky stocks. And sometimes you’ll get it wrong, even if you do all your due diligence.
But the best you can do is make sure you ARE doing your due diligence. And that starts with understanding what types of risks stocks have.
I want to share with you these 10 common stock risks that will dramatically affect your decision to buy a particular stock or not.
The 10 Most Important Stock Risks To Consider Before Buying
What people think or feel about a stock can influence the value of it. What’s interesting is nothing actually changed. We (investors) just feel a stock will succeed and buy it. If enough people behave like this, the companies share price will increase, which can prompt more people to buy the stock. Monkey see monkey do. Well… this isn’t obviously the case 100% of the time, but it’s human behavior to look at what others are doing to make our own decisions.
One of the BIGGEST ways we are influenced is through the media. If a news story came out that a certain company is rumored to merge with another company (when you acquire another company, you are by definition growing), you can expect speculators will jump at the chance to buy the stock while it’s “low”. These investors are anticipating that the merger will happen in the future, and also an increase in value and profitability to follow.
The type of stock risk you face here is media risk. Media risk can be good or bad. If the public is influenced enough, a company’s stock can rise or fall, even though nothing actually changed with the company. Public perception is HUGE when it comes to the value of a stock.
2. Political Risk
Political risk is a huge deal and something you basically can’t control. Political risk is the policies our government (or foreign governments) put in place that will affect the value of stocks.
For example, let’s say you live in an oil rich state. And let’s say a big oil company wants to build a large pipeline across the country. For this particular oil company, building a cross-country pipeline will keep them busy with work for years to come, and when they finish building the pipeline, they will be able to supply oil across the nation, further cementing profits. This project should increase the value of the company (not guaranteed). But, let’s just pretend the federal government decided that this project would be too publicly and environmentally unfriendly, and they kill the project.
This oil company may not be as valuable as its price indicates, or may not grow at the rate you are expecting because of political risk.
3. Liquidity Risk
Liquidity risk occurs when a stock lacks marketability. Basically, it means that there is a gap between what buyers are willing to pay for the stock and what sellers want to sell it at. This gap prevents the stock to be “liquid”, therefore posing a liquidity risk.
This can occur if there are insufficient buyers and/or sellers of the stock. Or there is a large enough difference between what buyers are bidding for the stock and what sellers are asking. This makes the stock riskier.
4. Currency Risk or Foreign Exchange Risk
A change in currency or expected future change in currency can hurt the value of a stock (or help it). Many companies rely on partnering with international companies to produce their goods and services.
I’ll give you an example. This isn’t an example of a stock, but you’ll be able to see how a difference in currency or changing currency will affect a companies ability to profit.
In the National Hockey League (NHL), there teams in Canada and teams in the United States. Let’s say the American dollar is trading at 1.4 times more than the Canadian dollar. And let’s say the team’s salary is $70 million USD per year. So if an American team wanted to max out the players salary, they would pay $70 million USD. If a Canadian team wanted to max out team salary, it would also cost $70 million. BUT, converted to Canadian dollars, $70 million USD = $98 Million CAD. So a Canadian hockey team needs to pay an extra 28 million dollars (because of the weak Canadian dollar relative to U.S. dollar). Do you think paying an extra 28 million dollars will affect the ability for a Canadian hockey team to profit? You better believe it! If the Canadian dollar was at a 1:1 ratio, where 1 CAD = 1 USD, then there is parity and there isn’t any currency risk.
Now, I used an example of a non-stock scenario to highlight company risk, but it’s the same idea for a publicly traded company. If a company relies on buying raw materials from a certain country at a low price, and that particular country’s currency shoots up, it means it will cost MORE money to buy the same materials. The result is less profitability. And if you are thinking about investing in this company’s stock, then you need to carefully consider its currency/foreign exchange risk.
5. Investment Risk
Investment risk occurs when a company you are considering investing in is in the process of (or planning to) take on a venture that will largely impact its future.
For example, Let’s say a cell phone company is in its prime and most people around the world are using their cell phones. Everything is peachy. And then lets say for whatever reason, this cell phone company doesn’t innovate and adapt to changes the market wants (larger screens, better cameras, more apps, etc). This company’s stock begins to fall and fall and fall… until it is on it’s last lifeline….
… now, in a last ditch effort to revive profits and get back in the game, this cell phone company is putting ALL IT’S EGGS in this last phone. Basically, if this final phone doesn’t profit, then this company is toast. If it succeeds though, they are looking at gaining back investors confidence and also a rise in their stock value.
In this situation, there is HEAVY investment risk. If you choose to buy this cell phone company’s stock, you need to really carefully consider the investment risk it has.
6. Sovereign Risk
Sovereign risk occurs when a government fails on repaying back loans it owes, or fails to pay owed interest payments. Though it happens at a government level, this can impact companies. This type of risk is more evident in what we call “emerging markets” where government isn’t as stable. It’s riskier investing in markets where government isn’t stable. You see this a lot in places that are war torn. It’s more difficult assessing the value of these companies and their ability to profit.
7. Financial Risk
Financial risk occurs when a company does not have enough cash on hand to meet it’s operational obligations. For example, if a company started to have money flow issues and can’t pay their employees, you can expect the employees to strike. This would obviously make the news and investors may become weary of the ability of this company to profit. Thus, they may avoid buying this stock and current stock owners may sell their shares, too.
Companies can raise money to solve financial risk. They can take out a loan or they can issue more stocks. You’ll want to watch out for companies that have outstanding loans and have issued a lot of shares. They basically have nowhere to go for more money. If you have identified that the company may face cash flow issues and they can’t raise more money, be very very cautious about investing in this company.
8. Systematic Risk or Market Risk
Market risk occurs when something happens that affects and entire market. This type of risk is something you need to carefully consider, but it’s hard to avoid and even predict.
A few examples of market risks are: wars, rising/falling interest rates, and recessions. A recession will affect an entire market sector (like technology, for example). No matter what you do, you are likely to see a fall in the value of your stock(s). Market risk can’t be eliminated or reduced by diversification.
Here’s another example: Let’s say the Federal Reserve (they print money) decided to hike interest rates to 10% all of a sudden (crazy example, I know). So all of a sudden you can earn 10% interest on much safer investments like bonds. What do you think will happen to stocks in general? People WON’T be buying as many stocks. Actually, the stock market would probably implode with a sudden hike in interest rate that high. Interest rate changes are a perfect example of market risk.
9. Credit Risk
Every company has credit risk. Many companies take out loans to fund their business needs. These loans obviously need to be paid back, plus interest. If a company is unable to pay off these interest payments or the principal, they can default and your investment can disappear. This type of risk is called credit risk.
10. Legal Risk
Legal risk occurs if a company could incur a loss due to legal factors. This could be from current legal proceedings or possibly future legal issues. Obviously, if the company you are thinking about investing in have done some shady stuff, they could be sued for it. This isn’t the easiest thing to assess, but it’s a necessary stock risk to consider.
What other things do you consider before you buy a stock? I’d love to hear about it in the comment section below.
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