We understand that there are numerous risks associated with investing in the stock markets. We try to understand and then classify these risks based on the behavior of stock prices in the financial markets. Knowing that investing in stock carries a certain amount of risk is probably one of the first things you should be aware of. This is because the returns on stock are not guaranteed; not by the government, not by the company issuing the stock, and certainly not by your broker. That means that there is a chance that your actual revenue will be different than what you had expected. For instance, you might purchase stock under the expectation that its price will rise steadily over time and that it will pay you annual dividends. However, if the company experiences financial problems, you may not receive the price appreciation or the dividends that you expected. Moreover, the company could even go out of business, in which case you could lose your entire investment. Because there is uncertainty regarding which of the various possible outcomes will occur, you bear a certain amount of risk when purchasing the equity.
How much of a risk does a stock carry in your overall portfolio? That depends upon what other investments are in your portfolio. In general, the risks associated with investing in stocks are greater than the risks associated with investing in bonds or money markets. At the same time, however, the risks associated with investing in stocks are less than the risks associated with investing in options or futures. Of course, not all stocks pose the same level of risk: some (such as internet stocks) are much higher risk than others (such as utilities), so it's important to understand the amount of risk you would be taking on with any given investment.
The other variable that will influence the amount of risk in your stock portfolio is your time horizon. Over long term, history has shown time and again that stock prices outperform almost all other investing options. However, in the short run stock prices often go down (about half the time, if the time period is sufficiently short). That means that if you are at a point in your life when you may need to sell your stocks in the short run, then you may want to think twice about investing in stocks. There is a definite possibility that the stocks that you buy now may be worth significantly less one or two years in the future. Most likely, however, they will be worth significantly more ten or twenty years in the future. So before you investing in stocks, you should sit down and examine both your own time horizons and those of the market in order to see whether or not you can take the risks associated with short term stock investing.
The most recognisable of all risks is the continual adjustment of a stock's price to new information entering the market. We recognize that there exists a strong relationship between new information and the price movements observed for a particular stock. People refer to this particular risk an investor faces from a potential movement in a stock's price, as 'idiosyncratic risk'. It is a risk that affects a very small number of assets, and can be almost eliminated with diversification
On closer examination of the behavior of stock prices, we also notice that there are relationships between stock price movements indicating inter-dependence. This is because when information pertaining to one stock is released to the market, it affects other stocks. There exists a correlation between movements in the stock prices. As a consequence there exists correlation between stock returns. Let us assume that this risk is called 'correlation risk'.
On a macro-level, we can also say that when information pertaining to all stocks is released to the market, certain stocks behave differently from others, and hence we can deduce that there must exist some relationship between stocks and the market as a whole. We refer to this risk as 'market risk or systematic risk'. Systematic risk cannot be diversified away, it can only be hedged, and is thus known as undiversifiable or market risk. This type of risk, associate with the market or market segments differs from the risk accompanying stocks in that systematic risk effects a broad range of securities whereas unsystematic risk affects a very specific group of securities or individual security.
In order to manage the risks associated with investing in stocks, most investors turn to a practice diversification or numerous other risk reducing strategies. Once you've thought about the risks associated with stock investing and figured out your plans for diversification, the next issue to consider when adding stocks to your portfolio is which stocks to add. As an investor one must consider their risk tolerance. Risk tolerance is a person’s emotional and financial capacity to ride out the ups and downs of the investing market without panicking when the value of investments goes down. To do so you'll first want to take a look at your particular investing objectives. If you're looking for steady income with low risk, you may want to consider investing in income stocks. On the other hand, if you're looking for opportunities that may result in a big payoff and you're not too concerned about the risks involved, you might want to try investing in growth stocks
