Risks of Investing in Stock Markets

Like with anything else in life risks and rewards go hand in hand in investing as well. Investing carries a certain amount of risk, and with that risk can come some pain, but also some gain. The old saying "no pain, no gain" is true for investing.

You must weigh the potential reward against the risks of an investment to decide if the “risk is worth the potential reward”. Understanding the relationship between risk and reward is a key piece in building your personal investment philosophy.

BUT, a lot of people fail to grasp the concept of risk. Case in point, leading up to 2008, people who were close to retirement had taken bigger risks than they could afford with their investments. They had borrowed money against their homes, invested in risky funds and assets. This triggered a massive sell-off during the recession in 2007-2009.

Because many people lost a lot of money during this panic, they kept their money on the sidelines to keep it safe from further losses. They did not begin entering the stock market until late 2012 and early part of 2013. But, it is a bit too late because they have missed a bigger part of market recovery. 

When the S&P 500 hit bottom on March 9, 2009, it was 56.8% off its all-time closing high of 1,565.15 on Oct. 9, 2007. Since reaching a low, however, the S&P 500 is up nearly 138 % as of 5/9/2013. This is an impressive performance and people would have benefited had they not sold their investments in the panic mode.

The gist of the matter is that people did not understand risk-reward equation. They did not understand it when they got into riskier investments in the first place, but also when they sold those assets in panic, and also when they sat on the sidelines watching the market recover. LESSON: Staying on the sidelines is risky as well.

The fact is, if the market drops sharply in a quick period of time, during the recovery period (which does come around eventually), you will see a sharp increase. What goes down eventually come back and vice versa. This is why you see stock market back up to all time high's today. If you understand this concept, it gives you strength to not lose courage when the going gets tough.

Research has shown that the investment mix of asset classes has far bigger influence on investment performance than individual investments themselves. Below is a chart of how 70% stocks and 30% bond asset mix has performed between 1926 and 2011. As you can see, for all major sharp downturns, few years after the bottom point, there are sharp upswings.

This is one reason why I focus so much on simple, low-cost, high-quality, index fund portfolios that cover the entire gamut of stock markets—domestic vs. international, developed vs. emerging, value vs. growth, small-cap vs. large caps, as well as bonds and REITs. When your portfolio is divided among these asset classes according to your risk tolerance, you are at that point optimizing your risk-reward equation for maximum benefits.

Plainly stated, achieving long-term financial goals means accepting the trade-off between risk and reward. It also means you have fully understood the historical patterns that have gone along with the three primary asset classes.

Stocks, historically, have offered higher long-term returns than bonds or cash, but they have also carried more risk. Bonds have offered higher returns, with more risk, than cash. Cash has provided a measure of stability, but money that is stuffed in your mattress nets zero return and will probably fail to keep pace with inflation. Paradoxically, not taking a risk with investing also poses the risk of your money losing its purchasing power due to inflation.

Risks of Investing in Stock Markets

Below are some of the risks you need to keep in mind when you invest in the stock markets either directly through stocks and bonds or through mutual funds, index funds, or ETFs. You should expect the your investments fluctuate within a wide range, like the fluctuations of the overall stock market.

Stock market risk

Stock markets tend to move in cycles, with periods of rising stock prices and periods of falling stock prices. Your value of the portfolio will decline during market downturns.

Country/Regional risk

If you invest in foreign market funds, then there would be a chance that world events—such as political unrest, financial troubles, or natural disasters—will adversely affect your portfolio. Country/regional risk is especially high in emerging markets. In general, the stocks of companies located in emerging markets will be substantially more volatile, and substantially less liquid, than the stocks of companies located in more developed foreign markets.

Currency risk

Foreign currencies often fluctuate against the US dollars due to changing market conditions. There will be chance that your investments will decline because of unfavorable changes in currency exchange rates.

Index sampling risk

The chance that the securities selected for the fund, in the aggregate, will not provide investment performance matching that of the index. Index sampling risk for the fund should be low.

Aggressive fund risk

Aggressive funds could pose risks due to concentration of fund holdings in a relatively low number of individual stocks, or in a particular sector of the stock market, or in a particular geographical region of the world; a heavy emphasis on small-capitalization stocks or growth stocks with relatively high market valuations; holdings of international stocks or bonds, which are subject to price declines caused by changes in the value of the U.S. dollar against foreign currencies; or investments in bonds that have exceptionally long average duration, whose prices are highly sensitive to changes in interest rates.

Actively managed fund risk

Fund managers of the actively managed funds may take risks by deviating from the original objective of the fund, or by chasing performance after a hot stock, or by constantly buying and selling securities than necessary. 

Stock-picking and timing risk

If you invest directly in individual stocks, then you run the risk of picking wrong stock or picking stocks at the wrong time.

How to Balance Risk-Reward Equation

Every investor needs to find his or her comfort level with risk and construct a balanced portfolio that optimizes one's risk tolerance. Your comfort level with risk should pass the “good night’s sleep” test, which means you should not worry about the amount of risk in your portfolio so much as to lose sleep if your portfolio were to drop by 50% in value. If you cannot sleep peacefully knowing this, then you would need to fine-tune your asset allocation by allocating more towards bonds and conservative asset classes.

Personally, there is no “right or wrong” amount of risk. If you are young, then can afford higher risk than the older investor can because you would have more time to recover if disaster strikes. If you are close to your retirement, you probably wouldn't want to be take extraordinary risks with your nest egg, because you will have little time left to recover from a significant loss.

You will have to do this on your own. You will find any standard guidelines that works for everybody. Frankly, if my money is on the line, I would spend some time thinking about the risks. It is a time well worth spending. I hope this helps you.