Investing in the stock market is about taking and managing risks. In a more rational world, investors would decide how much risk they were willing to take and what potential reward they expected.
Unfortunately, it is too common that investors in the stock market forget the fact that they could and at some point probably will lose money. This is especially true during up markets where it seems easier to make money than to lose money.
The risks of investing in the stock market should be well known to all investors. A quick review:
Market risk
Market risk is the danger that the whole market will slide for a variety of reasons, such as a struggling economy, concern over sagging profits and so on.
Your stocks may be dragged down when sellers out number buyers in the market and all stock prices fall. If you believe the companies you own are still strong and have a great future, this may be a good time to pick up some more shares at a reduced price.
Although markets go up and markets go down, you are never sure when prices are going to reverse direction. For the long-term investor, it is usually better to ride out the waves.
Investor Boredom
Investors face the problem of market risk, which is the possibility that your stock will fall out of favor with other investors. Maybe there is a really hot sector at the moment that is attracting buyers.
There may be nothing wrong with your stock, except it is just not in the hot sector at the moment. Of course, this can work in the opposite direction and you may find the stock you own is suddenly popular (a great time to consider selling some or all shares).
Poor Management
We like to think the stock we own is managed by the best and the brightest, however that isn't always the case. Companies may prosper for years, but then hit a rocky economy or changes in their business that prompt poor decisions.
Great managers do well in all types of economies and market conditions. Unfortunately, even good managers make poor decisions, such as diversifying into unfamiliar products or markets, failing to make needed changes such as automation, marketing and other key business strategies.
Judging the quality of management is a difficult and subjective exercise. Fortunately, there are many analysts who are more than ready to sound off about major changes in business models, market strategies and other key business decisions.
Economic Problems
Investors in the stock market should always be concerned about the national economy and how changes there can affect stock prices. A financial crisis, soaring unemployment, rising inflation (among many factors) can spell trouble for the stock market.
When the economy slows or stops, it is always trouble for the stock market. The issue is two-fold. If the economy is not growing, people and businesses tend to stop or reduce spending, which hurts immediate earnings.
Equally worse is the uncertainty about when the economy will rebound. This uncertainty makes companies cautious about expanding and hiring, which makes unemployment worse.
The economy will rebound, but when and at what pace?
Global Uncertainty
Many U.S. companies, especially the larger ones, have expanded their reach beyond the borders and do a large amount of business overseas.
This global diversification has often been a boon when business was slow domestically. Companies have been able to grow foreign markets, which can offset slowness in the U.S.
Of course this benefit is a two-edged sword. It has been helpful in the past, but when the global markets struggle, it spills into the U.S. market.
Economic problems in major economies such as Japan, China, India, the European market, Russia and others have a direct bearing on U.S. stock prices. Investors have learned that the U.S. is not an economic island immune from global economic dangers.
How do you protect your portfolio from global pressures? If you invest in large-cap stocks, you are exposed to the global market. Most large U.S. companies generate a substantial amount of revenue from overseas operations (in some case more than 50%).
When picking stocks, look for where the company does business overseas. Even if two companies are in different industrial sectors, they may share a risk by operating in the same foreign country or region.
Try to avoid companies that face the same potential global risks. In other words, don't hold just companies that invest in the same country or region. The benefits of global diversification can be more stability, while failing to minimize global risks puts you in a higher risk category.
