Risks of Stock Investments - Identify High-Risk Stocks
Legendary investor Warren Buffett defines investing as "...the process of investing money now to get more money in the future."
So investors, whether private or institutional, seek to grow their money over time by investing in one or more suitable financial instruments.
One of these suitable instruments is stocks. This article clarifies the basics of stock trading, how to identify high risk stocks and how to safely avoid them.
Table of Contents
Stock Investment: An Introduction
There is no such thing as a risk-free investment. Of course, understanding how the stock markets work is necessary before assessing the risks associated with stocks.
So, first and foremost, what are stocks and why do they exist?
When businesses require capital, such as to expand, they have two options:
- Borrow: This borrowed money must earn interest and be repaid at some point.
- Involve others in the company: One option for raising capital this way is to offer shares for sale to the public.
Shares are intangible (paper) items that represent a portion of the company's assets and profits. When a company sells shares, the buyers become shareholders, or co-owners.
An issue is another term for the issuance of shares. Companies can issue shares in a variety of ways:
- When a corporation is newly formed, the initial placement is going public. Alternatively, when converting another legal form to a stock corporation, an initial placement like this is commonly referred to as a "initial public offering" (IPO) or simply going public.
- The capital increase is the issue of additional new (so-called "young") shares.
- The stock split should not be forgotten. In this process, already issued shares are converted into a larger number of shares with a lower par value per share (sometimes known as bonus shares). The goal is to make the individual share cheaper and thus easier to trade.
Shareholders, taken as a whole, are the owners of a listed company. However, your say depends on how many shares you own in relation to the total shares issued by the company.
There are also two types of shares: common and preferred, each with its own set of benefits and drawbacks. The right to have a say or vote is one distinguishing feature.
Important business decisions of a stock corporation are usually made by voting among the owners at the Annual General Meeting. Holders of common stock have the right to participate in this vote.
Preferred shares generally cost more than common shares. However, these shares usually do not include voting rights. Now you may be thinking, "Paying more per share, but no voting rights - what's in it for me?"
If there's any doubt, the answer is more money. And this is accomplished through increased regular profit sharing (the well-known dividend). When a company is doing well and making profits, dividends are paid to shareholders, usually in cash. Furthermore, preferred stock pays higher dividends than common stock.
Furthermore, holders of preferred stock are prioritized among creditors if the company goes bankrupt. In comparison to common stock, you get your money back first - assuming there is any left to distribute.
The stock market is where the actual trading takes place. This, however, is a broad term. It refers to the extensive network of buyers and sellers who meet all over the world.
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Where does trading take place?
The stock exchange is a formally organized trading venue where brokers and investors trade stocks.
Most people have heard of the world's largest stock exchanges: the New York Stock Exchange (NYSE), the London Stock Exchange (LSE), or the Frankfurt Stock Exchange, where Germany's leading index, the DAX, was introduced in 1988.
Trading can also take place directly between buyers and sellers, which is known as over-the-counter trading. The latter is known as OTC trading.
Another distinction is between primary and secondary markets. The primary market is when a company issues shares in the previously mentioned IPO.
The fact that shares on the primary market are sold directly by the issuing company is important for understanding stock trading. In contrast, the company no longer trades its shares on the secondary market.
Investors are now trading amongst themselves. The stock market that you are most interested in as an investor is the secondary market, which is especially prevalent on the stock exchange.
The uniformity of share prices is a key feature of the stock exchange. The market price is established, and it applies to all market participants at any given time.
On the other hand, traders "make the market" on OTC markets. This is accomplished by stating the price at which they are willing to trade shares. However, this does not imply that they are quoted consistently across the network.
High Risk Stocks: Risks Involved in Trading
General Market Risk
Investments always involve a certain degree of risk. A thoughtful selection of financial instruments that match your investment objectives and risk profile will help manage the risk of investments.
However, keep in mind that there are risks associated with equities over which you have no control. The general market risk can be one of these.
These are risks, which can affect the entire market or even the entire economy. The value of your stock portfolio is thus influenced by factors other than the stock itself. Rather, it is a question of influences on the overall performance of financial markets, which could be global.
The four major types of market risk that investors face are listed below. Possible strategies for dealing with them are also discussed briefly.
In principle, external shocks can cause a downturn or even a full-blown crash on the stock markets at any time.
So-called black swan events (so called because they are as unusual and surprising as a black swan) can quickly affect the business cycle of individual economies and even the global economy.
Important examples in the 21st century are the 9/11 crash following the attacks on the World Trade Center in New York in September 2001, the crisis triggered by the collapse of the investment bank Lehman Brothers in 2008, or - most recently - the Corona crisis.
In such a situation, you suddenly find high-risk stocks in your portfolio that looked safe before the event.
However: the shrewd investor often recognizes attractive buying opportunities at such moments. As is well known, the stock market is rife with stock market wisdom. "Buy when the blood is flowing in the streets!" says banker Nathan Mayer Rothschild.
A basic strategy for hedging against economic swings is geographic risk diversification. Spread the stocks in your portfolio across different countries and exchanges. But also remember that when global crises hit, there is no longer a safe haven!
Inflation - the rise in the price of goods and services - reduces the purchasing power per unit of currency. Rising inflation has an insidious effect, especially when it is subtle.
Production inputs become more expensive, while consumers can purchase fewer goods. As a result, corporate revenues and profits are down, the economy is slowing, and equity risk is rising.
It takes time to find a new macroeconomic equilibrium after a downturn has occurred.
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The lack of marketability of an asset causes liquidity risk. As a result, a share, for example, cannot be bought or sold quickly enough to avoid or at least mitigate a loss.
An existing liquidity risk is usually reflected in unusually large bid-ask spreads (the spread between the buying and selling price) or sharp price movements.
As a general rule, the greater the liquidity risk, the smaller the volume of shares issued or the size of the issuer.
For example, the fall in the value of shares following the attacks of September 11, 2001, and during the global credit crisis of 2007/2008 motivated many investors to sell their holdings at any price. This "scramble for the exit" led to widening bid-ask spreads and large price declines, further contributing to market illiquidity.
Thus, safe stocks can turn into high-risk stocks without any change in the fundamentals of the company.
International diversification of stock investments has many advantages. It reduces the risk of relying too heavily on any one geography or business cycle and provide access to a much wider range of attractive companies.
There is one caveat, however: most foreign stocks are listed in their home currency. When you buy shares in such a company, their value is determined by fluctuations in the exchange rate in addition to changes in the share price.
For most investors, therefore, buying shares in a foreign company is not just an investment in stock market performance, but also in the currency involved.
This is where a highly interesting strategy comes into play, which should only be mentioned briefly at this point: One can hedge a stock portfolio with the help of CFDs (so-called hedging).
Aside from the aforementioned general market risks, such as macroeconomic developments, specific stock risks are unavoidably important.
Unfavorable corporate development is the most obvious risk associated with shares. One can only advise investors to keep in mind that a stock can only perform well if the company itself is healthy.
Nonetheless, it is amazing how often this simple principle is ignored. The dotcom bubble of 20 years ago was an enlightening negative example of this. When the bubble burst and many new industry companies went bankrupt, hundreds of thousands of investors in the United States, Europe, and elsewhere were left empty-handed.
However, as it turned out, many of them had no idea which shares they had purchased. Often, investors had no idea what product the company they were investing in was attempting to profit from.
"Panic on Wall Street!"
"The DAX takes cover!"
"Investors are frantically fleeing towards the exit!"
Everyone has probably read these or similar headlines in the financial press. Even in times of trading robots and computer algorithms that now seem to replace flesh and blood market participants, emotions are still a key factor.
Markets are ultimately driven by hope and fear, procrastination and greed. This is significant for each individual investor because the emotions of the masses can become the psychology of an entire market.
This can cause the mood to shift under certain conditions, even if there are no objective reasons for it. And all market participants are suddenly trading in the same direction.
Of course, seasoned investors like Warren Buffett are aware of this. One of his many well-known quotes is: "When others are greedy, be afraid. When others are afraid, be greedy”.
The direction in which the share price develops always reflects the risk inherent in shares.
The time horizon is crucial in this case. It is true that many stocks, particularly those of large, solid companies (dubbed "blue chips" because blue chips are traditionally the most valuable in poker) could be considered a safe option in the long run.
However, prices can fluctuate dramatically in the short term. Not just for risky stocks. Because of the irrational market psychology discussed above, unexpected downward or upward swings can occur.
Dividend payments are frequently the determining factor for total return for buy-and-hold investors who want to invest in a stock over the long term. If this fails to materialize or is only made at a low level, the portfolio's profitability may begin to deteriorate.
Stocks that do not earn any money can also be considered risky.
Finally, consider the following. In addition to the risks discussed above, don't overlook another risk to your wealth accumulation: the risk of being overly conservative. The risk of investing in stocks is frequently exaggerated.
High Risk Shares: How to Identify Them
No matter what the risk is, it always depends on the volatility, i.e. the fluctuation of the share price over time.
The greater the volatility, the riskier the stock. So, in traditional stock market investing, your goal should be to avoid risky stocks. To do so, you must first recognize them, which is usually difficult.
However, there are a few strategies that can assist you in identifying risk in stocks.
- Avoid flying blind. What sounds obvious often isn't: If you don't know how the company makes its money, don't buy the stock!
- Pick low-risk industry. Take a closer look at the industry of the company you want to invest in. Example: healthcare tends to be more stable than finance or technology.
- Review market capitalization. As a general rule, the lower a company's market capitalization, the riskier and more volatile it can be.
- Analyze beta factor. Beta is a capital market theory ratio. Simply put, it denotes the magnitude with which a stock's value changes in relation to the market. A beta greater than one indicates that the stock moves more in relation to the overall market (index). As a result, if the market falls 5%, the stock could fall 8%. The beta of a share can be found on common financial platforms on the Internet.
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Risky Stocks: How to Reduce Risk
Avoiding stocks with a higher risk is one thing. Minimizing risk itself when trading, is another.
Assume you've chosen stocks with acceptable risks and want to purchase them. To manage the risk, the traditional strategy is to avoid putting all of your eggs in one basket.
In essence, you are diversifying your holdings. Purchase at least four different stocks from various industries. You can also diversify geographically or by company size.
Also, don't forget to use stop loss marks even in traditional stock trading, but don’t overdo it. A too tightly set stop mark will quickly lead to your trading position being automatically closed, even though the price of the stock had only fallen below the mark for a short time - you will be stopped out!
An Alternative to Traditional Stock Trading
With Berkshire Hathaway, Warren Buffett has written a phenomenal success story. It's also based on value investing, which Buffett's mentor, Benjamin Graham, popularized.
In this process, shares of promising companies are identified through elaborate fundamental analysis. You take action if you find shares that are trading below their true value. Then you frequently hold these shares for years, before selling them at a profit at the right time.
In practice, this is more difficult than it appears. Many investors also prefer shorter time horizons and a more active trading role.
As a result, you should be aware that traditional stock trading is not the only way to invest in the stock market.
For example, did you know that you can invest on stock prices falling as well as rising?
This is possible, for example, with so-called leverage products such as CFDs (Contracts for Difference). What is the difference between stock and CFD trading?
Because CFDs are financial derivatives, their price is derived from an underlying asset. This underlying asset can be an index, a commodity, a currency, or another value such as a share.
CFDs, unlike shares, do not represent an investment in a company. Rather, the investor obtains a claim through the use of a CFD. Unlike stock investors, CFD investors only participate in the price development and fluctuations of the financial instrument, more specifically in the price differences.
Usually, CFDs are traded over the counter, i.e. OTC. For the trader, this means greater flexibility, as trading can be done independently of the standards and trading hours of the exchanges.
CFDs are leveraged products, which means that the investor does not deposit the entire trading volume in his account, but only a percentage as a margin. Thus, relatively large trading positions can be opened with comparatively little capital.
Another advantage of CFDs is the following: Since profit or loss results strictly from the difference between the entry and exit price, the investor can trade on both rising (long position) and falling prices (short position) of the underlying asset. However, the leverage of a CFD also creates the disadvantage of losing your entire capital in a single trade, as the leverage multiplies not only profits but also losses.
Investing in Stocks Despite the Risks
Ultimately, only you can answer this question for yourself. Every investment has its advantages and disadvantages. You have to weigh them up and reconcile the result with your own individual investment situation.
In any case, it remains to be said that the classic investment in shares can be see as one of the safest forms of investment of all. But it is a long-term project. As many studies have shown, a well-diversified portfolio will yield a decent return over ten or even 20 years.
The reason is actually quite simple: "The economy" consists of companies that strive for profits. And the value of the shares of successful companies increases.
If the global economy were to grind to a halt for a decade or two, then even the best stock portfolio would not be able to generate a return. But that would probably be the least of your problems.
What is true, of course, is that buying and holding stocks is not suitable for active day trading. And if prices fall, you're out of luck because you can't go short.
You can avoid these drawbacks by trading CFDs on stocks. However, in both cases, there is the theoretical possibility of total capital loss. However, you should be able to mitigate this risk with the necessary expertise, proper risk management, and a proactive trading strategy.
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