Risks Involved In Equity Stocks

The risk/return trade-off

This is one of the basic principles in investing: Taking reasonable risks could result in higher long-term rates of returns. Equity shares promise higher rates of return over the long term. On the other hand, debt instruments offer more stable but lower returns. As an investor, you should be able to judge whether the perceived risk is worth taking in order to get the expected return and whether a higher return is possible for the same level of risk and vice versa. The only way you can do this is if you are aware of all the risks that you are up against. Here’s a list of the more common risks that are attached to investing in equity.

Market/economy risks

These risks are not unique to any company and affect all stocks. They stem from factors related to the economy such as money supply, the level of government borrowing, the industrial policy, global economic conditions, etc. These are also known as non-diversifiable risks, since investors cannot avoid these risks, however diversified their portfolios may be.

Industry risk

This is the risk that applies to a specific industry and therefore, to stocks of companies belonging to that industry. A large scale shift in demand, a rise in input prices and regulatory changes are factors that augment such a risk. For instance, consumers’ preference for cheaper polyester clothing hampered the demand for cotton fabrics in the 1990s. Another example is the risk borne by Indian tyre companies when international prices of natural rubber rise.

Management risk

It is defined as the inability of the management to take decisions in the larger good of the company and its minority shareholders. Decisions that benefit only the company’s directors and its promoters would classify as a management risk. Further, even a shareholder-friendly management can be a risk if it is unable to manage a company’s growth in both good and bad times alike, and lacks the necessary dynamism to lead the company.

Business risk

Business risks mainly arise from the fact that a company’s earnings before interest and taxes (EBIT) can vary, depending on various factors. Demand is the first among these factors. If the demand for the company’s product is not stable or predictable, its revenue won’t be stable or predictable either. The company’s ability to increase prices or absorb cost increases is another key to its profitability. Companies differentiating their products through branding are better equipped to pass on cost increases and earn above average profits. Thirdly, if fixed costs are a substantial portion of total expenses, business risk is definitely higher (unless such costs also create a strong entry barrier) since the company’s earnings then are more susceptible to variations in demand.

Financial risk

Financial risks arise when debt represents a high proportion of the company’s capital structure (which comprises net worth and debt). A calling back of debt by the creditors or the company’s inability to secure adequate funds in future could result in a collapse in the operations of the firm whose stock you have invested in.

Exchange-rate risk

This risk arises out of variations in exchange rates of the rupee against the U.S. dollar and other major currencies. Profits of companies who import a relatively large part of their raw materials and those that export a large part of their goods or services are impacted when the rupee depreciates or appreciates, respectively. A weakness in the rupee also prompts foreign investors to withdraw from the stock market by selling their shares and converting those rupees into dollars. While they may re-enter at lower levels, the withdrawal of foreign investors often forces stock indices to tumble in the short-term, posing a big risk for domestic investors.

Inflation risk

Inflation can hit a company’s profits badly if it is not able to pass on the effects to consumers. In some cases, even if inflation eases, wage hikes can rarely be rolled back. Worse still, inflation can inflate corporate profits through overvaluation of closing inventory and this can lead to an increased tax burden.