We have sector & company specific risks in investing. Here we look at some universal risks that every stock faces irrespective of its business.
- Rating Risk – This occurs whenever a business is given a number to either achieve or maintain. Every business has a very important number as far as its credit rating is concerned. The credit rating directly affects the price a business will pay for financing. For public traded companies they have analysts rating which is even more significant value than the credit rating. Any changes to the analysts rating on a stock seem to have much bigger psychological impact on the market. The shifts in ratings, whether negative or positive often cause swings far larger than justified by the events that led the analysts to adjust the ratings.
- Commodity Price Risk – This is simply the risk of a swing in commodity prices affecting the business. Companies that sell commodities benefit when prices go up, but suffer when they drop. Companies that use commodities as inputs will get affected when we have swings in prices, in addition this may affect the whole economy especially when commodity prices go up as people restrain from spending.
- Headline Risk – This is the risk associated with stories in the media that will hurt a company’s business. One bit of bad news can lead to a market backlash against a specific company or an entire sector.
- Obsolescence Risk – This is a risk that a company’s business may become obsolete. The biggest obsolescence risk is that another person may find a way to make a similar product at a cheaper price.
- Detection Risk – This is the risk associated with the auditor, Regulator or any other authority that checks your business compliance to the set requirements or standards. If the companies earnings or any other financial malpractices are happening, the market reckoning will come when the news surfaces. With the detection risk, the damage to the company’s reputation may be difficulty to repair and in some cases, the company may never recover.
- Legislative Risk – This risk refers to the tentative relationship between government and business. Specifically it is the risk that government actions will constrain a corporation or industry, thereby adversely affecting an investor’s holdings in that company or industry. This risk can be realized in several ways: new regulations or standards, specific taxes etc.
- Model Risk – This is the risk that the assumptions underlying economic and business models within the economy are wrong. The mortgage crisis or 2008-2009 is a perfect example of what happens when models don’t give a true representation, in this case risk exposure model doesn’t give a true representation of what they are supposed to be measuring.
- Inflation Risk and Interest Rate Risk – Interest rate risk, refers to the problems that a rising interest rate causes to businesses that need financing. As their costs go up due to interest rates, it is harder for them to stay in business. If this rise in rates is occurring in a time of inflation, and usually rising rates are used to fight inflation then a company could potentially see its financing costs climb as the value of the dollars its bringing in decreases. A rise in interest rates and inflation combined with a weak consumer can lead to a weaker economy.
Every investor should know that there isn’t a risk-free stock or business. The rewards of investing can still outweigh the risks that every stock faces be it universal risks or risks specific to the business. The best thing to do as an investor is to know the risks before you buy in.