Investing, in general, comes with risks, but thoughtful investment selections that meet your goals and risk profile keep individual stock and bond risks at an acceptable level. However, other risks you have no control over are inherent in investing. Most of these risks affect the market or economy and require investors to adjust portfolios or ride out the storm.
Here are four major types of risks that investors face, along with some strategies for dealing with the problems caused by these market and economic shifts.
One of the most obvious risks of investing is that the economy can go bad at any given moment. Following the market bust in 2000 and the terrorist attacks on September 11, 2001, the economy settled into a sour spell, and a combination of factors saw the market indexes lose significant percentages. It took years to return to levels close to pre-September 11 marks, only to have the bottom fall out again in the 2008 financial crisis.
For young investors, the best strategy is often to hunker down and ride out these downturns. If you believe in the long-term return of the capital markets and you are liquid at moments of crisis, you can use the temporarily lower prices to increase your positions in solid companies that perform well over the long term. This means buying more of the stocks you like at the bad times of the market.
Foreign stocks can be a bright spot when the domestic market is in the dumps, and thanks to globalization, some U.S. companies earn a majority of their profits overseas. However, in a collapse like the 2008 financial crisis, there may be no truly safe places to turn.
Older investors are in a tighter bind. If you are in or near retirement, a major downturn in the stock market can be devastating if you haven't shifted significant assets to bonds or fixed-income securities. This is why diversification and adjusting your portfolio's asset allocation as you age is essential for investing.
Inflation is the tax on everyone, and if it's too high, it can destroy value and create recessions. Although we believe inflation is under our control, the cure of higher interest rates may, at some point, be as bad as the problem. With the massive government borrowing to fund the stimulus packages, it is only a matter of time before inflation returns.
Investors have historically retreated to hard assets, such as real estate and precious metals, especially gold, in times of inflation, because they're likely to withstand the change. Inflation hurts investors on fixed incomes the most since it erodes the value of their income stream. Stocks are the best protection against inflation since companies can adjust prices to the rate of inflation. A global recession may mean stocks will struggle for a protracted amount of time before the economy is strong enough to bear higher prices. It is not a perfect solution, but that is why even retired investors should maintain some of their assets in stocks.
Market Value Risk
Market value risk refers to what happens when the market turns against or ignores your investment. It happens when the market goes off chasing the "next hot thing" and leaves many good, but unexciting companies behind. It also happens when the market collapses because good stocks, as well as bad stocks, suffer as investors stampede out of the market.
Some investors find this a good thing and view it as an opportunity to load up on great stocks at a time when the market isn't bidding down the price. On the other hand, it doesn't advance your cause to watch your investments flatline month after month while other parts of the market are going up.
Don't get caught with all your investments in one sector of the economy. By spreading your investments across several sectors, you have a better chance of participating in the growth of some of your stocks at any one time.
Risk of Being Too Conservative
There is nothing wrong with being a conservative or careful investor. However, if you never take any risks, it may be difficult to reach your financial goals. You may have to finance 15–20 years of retirement with your nest egg, and keeping it all in low-interest savings instruments may not get the job done. Younger investors should be more aggressive with their portfolios, as they have time to rebound if the market turns bad.
Frequently Asked Questions (FAQs)
What is gamma risk in the stock market?
Gamma risk refers to one of "the Greeks" that options traders use to analyze options contracts. Gamma measures the volatility of another Greek known as the Delta. The higher the Gamma, the more sensitive an option will be to swings in the price of the underlying stock. This usually occurs when the option is close to the money. Low-Gamma options contracts are likely either deep in the money or deep out of the money.