Benjamin Graham, popularly known as the father of value investing, once rightly said, “The essence of investment management is the management of risks, not the management of returns.” Managing risks is an inevitable part of your investing journey. Moreover, the quality differentiating successful traders from the rest is their approach toward managing risks.
While you invest in the stock markets to generate wealth, it is important to understand the risk-reward concept. This principle revolves around the idea that higher risks increase the potential for higher returns and vice versa. One rule is unquestionably valid in investing: equities generate rewards while debt offers safety. According to the traditional 60/40 rule, 60% of a portfolio should be allocated to stocks and the residual to bonds.
Notably, the investment markets offer several choices to invest money. However, each of these investment vehicles has some risk associated with it. For instance, market participants can consider investing in the upcoming IPOs, which are expected to maintain strong momentum in 2023. However, these offerings will remain exposed to macroeconomic risks like inflationary and geopolitical concerns.
Therefore, investors need to understand the potential risks and returns associated with stock market investments to build a successful portfolio and design impactful risk management strategies.
How Does the Stock Market Reward You?
Dividends and capital gains are the two primary categories into which earnings from stock markets can be divided. Capital gains are further divided into short-term and long-term gains depending on how long a capital asset is held. Contrarily, dividends are the portions of profits paid out to shareholders on a per-share basis.
The benefits are:
- Opportunity to participate in the company decisions through e-voting
- Possibility of earning an annualized return higher than the inflation rate
- It is simple to purchase company shares on the stock market
Potential Risks in Stock Market Investments
To enjoy the benefits, investors must open a Demat account online and start investing but let us remind you of a disclaimer that share market investors commonly encounter: Investments in stock markets are subject to market risks! So, let’s move ahead with our discussion on the several types of potential risks to consider before making investment decisions.
- Undiversifiable Risk or Systematic Risk
This is also popularly known as Market risk primarily because it is associated with the risk of loss resulting from circumstances with an overall market- or asset-class. It is highly unpredictable and inherent to the stock market. Interest rate, currency exchange rates, etc. are some risk factors that impact the entire market.
To manage the effects of systematic risks, investors can resort to strategies such as hedge portfolios, invest in contra-market return products or popular correlated market products.
- Diversifiable Risk or Unsystematic Risk
Investing world also calls this risk a Specific risk or Residual risk. Unsystematic risks can be associated with the individual company or the wider industry. It frequently applies only to a single organization because of its management, financial commitments, or geographic location. Contrary to systematic risk, unsystematic risks can be minimized through portfolio diversification.
- Inflation Risk
Also known as Inflation risk, it is the likelihood that an investment’s cash flow may eventually lose value due to a reduction in its buying power due to inflation. All investment types carry some level of inflation risk.
One method to avoid inflation risk is to adjust your portfolio and choose investments that provide a higher rate of return after accounting for inflation.
- Liquidity Risk
Liquidity risk pertains to availability of buyers and sellers in the market. It is the danger of not being able to buy or sell assets at a specific price during a given time frame due to the absence of a counterparty
Notably, before purchasing any asset class, investors should look at the traded volumes, market depth, etc. to minimize liquidity risk.
- Taxability and Regulatory Risks
When a nation changes its tax laws, it can have impacts on certain sector or industry. Sectors, like pharmaceutical, telecommunication, tobacco, etc., are under high scrutiny by government regulatory bodies. Therefore, companies operating in such sectors are highly susceptible to any alterations to existing laws or the imposition of new legislation.
Risk cannot be avoided in stock market investing, but it may be faced and managed. A few risk management practices that any investor may consider are – keeping cash at hand, monitoring portfolio performance in comparison to the market and adhering to the investment strategy.
And, as a bonus, you can sharpen your stock market trading concepts by reading more interesting articles on the Bajaj Securities website. On the other hand, after this elaborate discussion on the risk rewards associated with stock markets, if you feel confident enough about your skills, open a Demat account online by visiting the Bajaj Securities website.
We wish you all the best in your investing journey!