5 investment risks to be aware of
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This article originally appeared on the Morningstar India website.
Potential pitfalls are baked into practically all levels of investing. Some risks are specific to certain investments, while others have broader effects.
Risks can originate from a variety of sources, including surprising economic or political events, bubbles, and faltering companies and countries.
Here is an overview of five major types of risks, but it's important to recognise that they do not function in a vacuum. Rather, multiple types of risk are often linked and feed off of each other, magnifying the impact on your investments.
Also referred to as volatility, market risk means your investments are subject to largely unpredictable day-to-day fluctuations in trading activity. Investor panic and euphoria can send prices bouncing unpredictably, even if an investment's fundamentals are sound.
Often a negative headline will cause a stock's price to slide, whether the issue is temporary or not. Market risk also includes the possibilities of interest rates or currency exchange rates changing.
The "flash crash" is an example of market risk. (At around 2:42pm EST on 6 May 2010, the US stock market began a swift decline that has since become known as the "flash crash"--with "flash" referring to "flash" trading, a process that uses computers to execute lightning quick trades. While the market quickly pulled out of its nosedive, it was a blow to investors' confidence in the market.)
It remains unclear precisely what caused the market to slide so much initially, but once the decline began, it triggered a chain reaction, including automatic sell orders, which sent stocks further downward.
Market risk becomes a big problem for investors who need to sell their holdings in a down market to raise cash. An asset's price in the short term may not accurately reflect its value based on longer-term fundamentals, but investors without the time, patience, or stomach to ride out a down market often end up locking in their losses by selling at or near the trough.
Economic risk refers to the possibility of an economic shock or weakness weighing on your investments. Economic shock can encompass a number of scenarios and are commonly unexpected, such as an oil shock that creates panic in the stock market.
The US housing crisis was an example of economic risk--a real estate bubble spread to financials and into the market more broadly.
Another example would be an investment in a luxury goods company performing poorly because of a recession. Changes in interest rates present another economic risk factor, affecting the costs of borrowing and the value of interest-rate sensitive bonds.