Page 46 - DIY Investor Magazine | Issue 41

· August 2024 46
DIY Investor Magazine
WHEN INVESTING IN SHARES, BE AWARE OF THE RISKS YOU COULD BE EXPOSED TO – BY JANNES LORENZEN
When investing in shares, be aware of the risks you could be exposed to – by Jannes Lorenzen.
You can make good profits investing in the stock market – the average annual return of the S&P 500 Index since 1957 is 10.3% - but there are no risk-free investments; the higher the return, the greater the risk.
1. MARKET RISK
Market risk refers to the fact that the value of shares is influenced by fluctuations on financial markets, triggered by various factors, including:
Global economic events: News about economic growth, inflation, interest rates, employment figures and other macroeconomic indicators affect investor sentiment and consequently share prices.
Fiscal and monetary policy: Decisions by governments and central banks regarding monetary policy, such as interest rate, can significantly impact equity markets.
Changes in market conditions: Factors such as liquidity and investor confidence can affect share prices; a volatile market can lead to unpredictable price movements.
Geopolitical events: International conflicts, trade tensions and elections cause uncertainty, dragging down share prices.
Technological change and innovation: New technologies and innovations can influence the prospects of companies and therefore the value of their shares
Risks are uncomfortable, but fluctuations are why returns on stock market investments can be higher than less risky investments. These are just some of the risks, and we will show you what options exist to manage them cleverly.
2. SECTOR OR COUNTRY RISK
Sector or country risk is associated with the sector or country a company you invest in operates; you automatically expose yourself to the specific risks of that sector or country.
Different sectors react differently to macroeconomic changes and economic cycles. Sectors such as technology and cyclical consumer goods, for example, are more sensitive to changes in economic growth than sectors such as food and consumer staples, which are less cyclical.
The technology sector is characterised by rapid change and innovation, but when you invest in Apple, for example, a risk is that it is unable to keep pace with technological developments and loses its competitiveness.
A renewable energy company in Brazil, could be affected by political instability or internal political conflicts.
3. EXCHANGE RATE RISK
Investing in foreign shares exposes you to exchange rate risk, as your returns can be affected by the movements between the pound and the foreign currency.
Investing in shares in a US company such as Microsoft, may expose you to currency risk; eg if a pound is worth $1.10 at the start of your investment, and you buy Microsoft shares for a total of £10,000, you’ll receive the equivalent of $11,000. If the dollar appreciates against the sterling over time, you will receive fewer pounds for the same dollar amount when you sell – potentially leading to losses.
HOW CAN THESE RISKS BE MINIMISED?
Maintain a diverse portfolio; don’t concentrate your money on just a few stocks, spread it across several stocks and asset classes to reduce overall risk. Strategies to achieve diversification include:
Asset allocation: Investing across asset classes such as shares, bonds, investment funds, property or commodities.
Sector diversification: Investing in different industries reduces sector-specific risks.
Geographical diversification: Invest across different countries or geographical regions.
Diversification between high-risk and low-risk investments: Balance high-risk investments such as equities and low-risk investments such as bonds.
You can eliminate almost all “unsystematic” risks through diversification:
Unsystematic risks – are things like individual value risk or management errors that can lead to a company’s imbalance or bankruptcy.
Systematic risks – i.e. the risk associated with an asset class – cannot be eliminated.
Collectives such as ETFs increase diversification, but systematic market risk remains, characterised by higher volatility, among other things. However, if you are aware of existing risks and know how to avoid or limit them, there is hardly anything standing in the way of your stock market success.
INVESTING BASICS: 3 RISKS YOU NEED TO KNOW BEFORE INVESTING IN STOCKS