When you invest in the markets through the equity route, there are various risks that you take. These risks are essentially generated because of the nature of the asset itself. Also, you take on all the risks that the company, in which you have invested, faces since the return on your money depends on the performance of the business. Though there are various risks, they can be broadly categorized under three heads.
When you invest in a stock, you invest in a business, which is run by a company and its managers. Hence, indirectly you take on the risk of the business going bad. General global and domestic business scenario, government regulation and sector competition are some of factors that constitute business risk. An investor should look at the business model in which the company operates and whether the model is likely to work.
Business risk also includes losing out to peers or succumbing to market pressure. So an investor should consider the position or market share of the company and assess if the company will be able to survive competition.
The state of a specific industry, whether it is in a growth, maturity or decline phase of the business cycle, also falls in this category.
Financial risks primarily involve the cash flow and profit situation of a company. An investor should look at the company’s financial statements and other financial information to ascertain if the company is financially sound. The capital structure of the company will also tell an investor about this parameter. For instance, if a company has taken up too much debt apart from raising money from the shareholders, that company runs a high risk. Alternatively, if a company has a low debt-equity ratio, then the capital structure is more stable. One way investors can check if this ratio is manageable or not is by comparing it with peers as different companies in different sectors operate under unique financial obligations. So what is true for one sector may not be true for the other. At the same time, too much equity may lead to earnings per share getting diluted, thereby not benefiting minority shareholders. So, both too much equity and debt is not good for the firm’s share price.
Market risks pertain to the risks associated with the stock market. Stocks are publicly traded with investors from India as well as abroad putting in their money. Hence, if the investor sentiment turns bearish or the general market scenario is in turmoil, investors may withdraw money from the market, affecting the stock you have invested. For example, during the 2008 market crisis, all shares lost ground, irrespective of a good or bad company. However, it is true that stocks which enjoy market confidence and have funadamentally sound business recover faster than others. One can spot such stocks by looking at the traded volumes. However, keep in mind that a stock with falling prices may also show high trade volumes as many investors would be exiting it.