There are many sector specific and even company specific risks in investing. In this article, however, we will look at some universal risks that every stock faces, regardless of its business.
TUTORIAL: Risk And Diversification
Commodity Price Risk
Commodity price risk 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 see the opposite effect. However, even companies that have nothing to do with commodities, face commodities risk. As commodity prices climb, consumers tend to rein in spending, and this affects the whole economy, including the service economy. (For related reading, see Commodity Prices And Currency Movements.)
Headline risk is the risk that stories in the media will hurt a company's business. With the endless torrent of news washing over the world, no company is safe from headline risk. For example, news of the Fukushima nuclear crisis, in 2011, punished stocks with any related business, from uranium miners to U.S. utilities with nuclear power in their grid. One bit of bad news can lead to a market backlash against a specific company or an entire sector, often both. Larger scale bad news - such as the debt crisis in some eurozone nations in 2010 and 2011 - can punish entire economies, let alone stocks, and have a palpable effect on the global economy.
Rating risk 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 goes. The credit rating directly affects the price a business will pay for financing. However, publicly traded companies have another number that matters as much as, if not more than, the credit rating. That number is the analysts rating. Any changes to the analysts rating on a stock seem to have an outsized psychological impact on the market. These shifts in ratings, whether negative or positive, often cause swings far larger than is justified by the events that led the analysts to adjust their ratings. (For related reading, see What Is A Corporate Credit Rating?)
Obsolescence risk is the risk that a company's business is going the way of the dinosaur. Very, very few businesses live to be 100, and none of those reach that ripe age by keeping to the same business processes they started with. The biggest obsolescence risk is that someone may find a way to make a similar product at a cheaper price. With global competition becoming increasingly technology savvy and the knowledge gap shrinking, obsolescence risk will likely increase over time.
Detection risk is the risk that the auditor, compliance program, regulator or other authority will fail to find the bodies buried in the backyard until it is too late. Whether it's the company's management skimming money out of the company, improperly stated earnings or any other type of financial shenanigans, the market reckoning will come when the news surfaces. With detection risk, the damage to the company's reputation may be difficult to repair – and it's even possible that the company will never recover if the financial fraud was widespread (Enron, Bre-X, ZZZZ Best, Crazy Eddie's and so on). (For related reading, see Detecting Financial Statement Fraud.)
Legislative risk refers to the tentative relationship between government and business. Specifically, it's the risk that government actions will constrain a corporation or industry, thereby adversely affecting an investor's holdings in that company or industry. The actual risk can be realized in a number of ways - an antitrust suit, new regulations or standards, specific taxes and so on. The legislative risk varies in degree according to industry, but every industry has some.
In theory, the government acts as cartilage to keep the interests of businesses and the public from grinding on each other. The government steps in when business is endangering the public and seems unwilling to regulate itself. In practice, the government tends to over-legislate. Legislation increases the public image of the importance of the government, as well as providing the individual congressmen with publicity. These powerful incentives lead to a lot more legislative risk than is truly necessary.
Inflationary Risk and Interest Rate Risk
These two risks can operate separately or in tandem. Interest rate risk, in this context, simply refers to the problems that a rising interest rate causes for businesses that need financing. As their costs go up due to interest rates, it's harder for them to stay in business. If this climb in rates is occurring in a time of inflation, and rising rates are a common way to fight inflation, then a company could potentially see its financing costs climb as the value of the dollars it's bringing in decreases. Although this double trap is less of an issue for companies that can pass higher costs forward, inflation also has a dampening effect on the consumer. A rise in interest rates and inflation combined with a weak consumer can lead to a weaker economy, and, in some cases, stagflation. (Learn which tools you need to manage the risk that comes with changing rates. For more, see Managing Interest Rate Risk.)
Model risk is the risk that the assumptions underlying economic and business models, within the economy, are wrong. When models get out of whack, the businesses that depend on those models being right get hurt. This starts a domino effect where those companies struggle or fail, and, in turn, hurt the companies depending on them and so on. The mortgage crisis of 2008-2009 was a perfect example of what happens when models, in this case a risk exposure model, are not giving a true representation of what they are supposed to be measuring.
The Bottom Line
There is no such thing as a risk-free stock or business. Although every stock faces these universal risks and additional risks specific to their business, the rewards of investing can still far outweigh them. As an investor, the best thing you can do is to know the risks before you buy in, and perhaps keep a bottle of whiskey and a stress ball nearby during periods of market turmoil.
Stock AnalysisRead about the biggest risks facing search-engine conglomerate Google Inc. shareholders, especially the risks of increased government regulations.
InvestingAfter October’s better-than-expected employment report, a December Federal Reserve (Fed) liftoff is looking more likely than it was earlier this fall.
InvestingWhile stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
RetirementWe discuss the advantages of seeking professional help when it comes to managing our retirement account.
Investing BasicsLearn why interest rates are one of the most important economic variables and how every individual and business is affected by rate changes.
EconomicsAfter the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
ProfessionalsLearn what credit risk analysts do every day and how much money they make on average, and identify the skills and education needed for this career.
Chart AdvisorThere has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
ProfessionalsLearn what a typical early morning to late evening workday for a hedge fund manager consists of and looks like from beginning to end.
EntrepreneurshipLearn how a complete risk management plan can minimize or eliminate your financial exposure through insurance and prevention solutions.
Secured loans are better for the borrower than unsecured loans because the loan terms are more agreeable. Often, the interest ... Read Full Answer >>
Individuals with valid Social Security numbers are permitted to receive up to three credit reports every 12 months rather ... Read Full Answer >>
Transfer pricing refers to prices that a multinational company or group charges a second party operating in a different tax ... Read Full Answer >>
Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
The Canada Pension Plan protects pension holdings against inflation and adjusts its annual rates for inflation. The Canada ... Read Full Answer >>
Mutual fund investors have numerous items to consider when selecting a fund, including investment style, sector focus, operating ... Read Full Answer >>