As much as we’d all love to live in a world where bad things never happen, the unfortunate reality is nearly everything in life involves some kind of risk. Whether we are driving to work, playing sports, or having children, we are taking risks every day. Many of these risks are so low we may never even consider them, while others are high enough to make us avoid them altogether. Additionally, willingness to take on risks varies from person to person, as does the amount of effort made to mitigate, or lessen, those risks if we choose to participate in those activities.
Investing in stocks—or any financial asset, for that matter—is no different. There are many risks involved in buying and selling stocks, and each of us has a different appetite when it comes to the types, size, and number of companies we select for our portfolios. Some of us have heard too many horror stories from people who have lost everything in the market and avoid it completely, while others are willing to risk it all on “meme stocks” or highly-volatile cryptocurrencies. Most of us fall somewhere between these two extremes, opting to take some risk to grow our wealth but not so much that one bad move could derail our whole financial plan.
Below, we take a look at some of the risks involved when investing in the stock market, as well as some strategies that can help alleviate these risks.
Market, or economic, risk is any risk that has a wide-reaching effect across the economy and, by extension, the stock market. Examples of this type of risk are wars, natural disasters, pandemics, or inflation. Because they affect the stock market more or less as a whole (with few exceptions), you cannot avoid them—if you are invested in stocks, you are exposed to market risk.
The best defense against market risk is an appropriate asset allocation. This means only having a certain percentage of your net worth in various asset classes, such as stocks, bonds, cash, or real estate. The appropriate mix differs for each of us, depending on our age, net worth, willingness to take risk, and a host of other personal factors. Typically, the closer you get to retirement, the less exposure you should have to the stock market, since stocks are historically one of the more volatile asset classes. If you have a large percentage of your retirement nest egg allocated to them just before you retire and an unforeseen event causes a big correction in the stock market, you may find yourself having to reevaluate what your retirement is going to look like.
As its name suggests, specific risk is any risk associated with any one company or industry. Failure of a company’s management to properly manage the amount of debt their company takes on can negatively affect its share price. A particularly bad hurricane season may impact the profits of insurance companies as they are forced to pay more claims than expected.
These types of risks are also known as unsystematic or diversifiable risks. They are unsystematic because they do not affect the stock market as a whole. Since they are unique to one company or industry, you can protect your portfolio against these risks by diversifying across a broad range of unrelated companies and industries.
While market or specific risks involve external forces mostly outside of our control, investor risks are those over which we can exercise some level of control. Some of the most common types of this risk are cognitive biases, market timing, lack of diversification, and fear or overconfidence. These can often times work hand-in-hand, so it’s important to understand how each of them can affect your decision making.
As can readily be seen on any social media platform, there is no shortage of opinions on what’s happening in the world. Each of us has different perspectives shaped by a broad range of personal experiences and beliefs. It should be no surprise, then, that we all have varying views when it comes to the stock market or the individual companies and industries that form it. When it comes to building and managing a portfolio, however, we should not allow these personal feelings to get in the way of prudent decision making. Strong positive emotional attachment to a certain company can lead to being overexposed to that company’s performance. An overwhelming fear of a market correction can prevent participation in an increasing market should that correction never materialize.
They key to navigating any risk is a purposeful plan to reduce the effect the risk has on your wellbeing. When it comes to investing in the stock market, the key to protecting your portfolio from the above risks is a sensible, methodical investment strategy devoid of too much emotional interference. If you choose the DIY route, make sure you understand the risks associated with the investments you are making and the best ways to protect against them. If you’d rather delegate to a professional, make sure they are a fiduciary that will look out for your best interest and welcome the opportunity to explain how they plan to protect your portfolio.
The information presented in this article is for educational purposes only and is not meant to provide individual advice to the reader. There is no guarantee the information provided above relates to your personal situation. All financial situations are unique and should be advised as such.