One of the most common reasons why many investors avoid entering the stock market is the element of risk associated with investments. Despite the lure of attractive returns, many people in India not only do not take advantage of the instrument but also advice others from entering. Due to this reason, the stock market is unfairly stigmatised as a variant of a lottery. This cannot be further than the truth, because in the share market, the luck factor only plays a minor role, whereas it is the skills and the learning on the part of the investor which plays the major role.
The much talked about risk that is associated with the stock market is present either for those people who do not have a clear understanding of the workings of the share market business, or those who are not able to learn from their mistakes. In these cases, a self-introspection and a bit of homework can easily iron out the errors. A good understanding of the workings of the market and the risks associated with it will enable the investor to plan a strategy to mitigate the risks and in the process enhance chances of profit. Hence, the stock market is risky for those people who invest without analysing the market.
Two Major Types of Risks in the Stock Market
The stock market can be a reliable platform to invest your hard earned money and get attractive returns if you are able to understand and mitigate two types of risks.
i. Systematic Risk: Non-diversifiable risk or systematic risk is related to the relationship between the market as a whole and the price of a particular investment. Unfortunately, to a certain degree, this type of risks are unavoidable. This is because usually when the market in its entirety plunges by a certain margin, there is a good possibility that the stocks under it will witness a drop as well. Those people who are aware of the concept of data will understand that this the metric that can describe the systematic risk of a stock and will be able to identify how reactive a particular stock is to the movements of the overall market.
ii. Unsystematic Risk: On the other end of the spectrum is the diversifiable risks or unsystematic risks. In this case, it is related to the ownership of a particular investment. This means that if you own the share of a particular company and its latest product performs poorly, then that will directly cause the stock’s price to nosedive. That is an unsystematic risk that is applicable to the company only.
Analysis and Mitigation of Systematic Risk
As mentioned before, systematic risk is subject to the overall risk to the stock market. The great recession of 2007-08 is a good example of systematic risk. During that period the condition was such that the banking system was threatening to collapse, unemployment reached an all-time high, and the values of homes reached a new low. All these factors came into play and resulted in the plummeting of the stock market.
The stock market witnessed a dramatic drop from the highs of early 2007 to the severe lows in 2009. Needless to say, the prices of the majority of the declined. This point highlights the point that the systematic risks are not specific to the company that you are investing in. A culmination of economic weaknesses poses the threat of systematic risks. One way of countering this threat is by investing in recession-resistant stocks.
Although opting for stocks that are recession resistant is an option, it is not the ultimate option. The option to counter the effects of systematic risks is time. Like in most cases in the stock market, time is an answer to this problem too. To simplify the explanation, the market does go through trends where it faces a loss over a stretch of time, however, when looked at it from a long term point of view it always recovers stronger. This is represented by the historically upward trajectory of the stock market curve overall. So for those investors who are looking to invest in the long term, the issue of systematic risk is not much. This is because over a period of time it is bound to recover stronger and give you good returns.
Unsystematic risks are also referred to as diversifiable risks. Hence, one of the most effective ways to mitigate this type of risk is to diversify the portfolio carefully. This is where investment options like exchange-traded funds and mutual funds come in handy, as they automatically diversify the portfolio. Let us take the example of exchange-traded funds if an investor purchases 100 exchange-traded funds then his or her money will be spread across 100 stocks, thus mitigating the impact of individual company-specific risks on the performance of the investments.
Simultaneously, if you are an investor who plans on investing in individual stocks only, then more time and energy has to be invested. In the case of individual stock investment, the investor is required to invest in at least ten to fifteen different types of stocks, in a wide variety of industries that have different types of company-specific risks. For this, the investor not only needs to be financially aware but also have to be up-to-date with all the latest developments related to the different industries.
The investors have to be careful that they do not dedicate too much portion of the total portfolio to a particular company, no matter how profitable it may be. This will ensure that even it fails, it will only have a marginal effect on your overall performance and not be a significant blow.
Reliability of the Market
From a reliability point of view, the stock market tends to be more reliable as far as long term is considered. It faces minor blips over short terms, but it eventually returns to normalcy. This is why long-term investments are considered to be less of a risk than short-term investments. This being said, the short-term investments do have its share of risks, but it is not the type of risk which cannot be mitigated.
One needs to be smart with the investment choices, especially when intended for the short term. For this purpose thorough market research and analysis is required. It can also help to know read market reports and study previous trends of the stock market. This can give the investor a rough idea as to how the market behaves in times of uncertainty so that the investor can make better decisions and make profits even when the market is not at its best.