The 3 Basic Categories of Investment Risk
If you are a smart investor, then managing the possible risks should be a habit of yours. There exists 3 dissimilar investment risks that you should protect against for any investment you make, be it a stock, mutual fund or bond. These three types of risks associated with investment are business risk, evaluation risk and force-of-sale risk. You can find out about all of these types of risk from business books or by reading on. The investing in stocks can be tricky so make sure your stock market education is sufficient.
Most likely, business risk is the type of investment risk that is most familiar and easiest to understand. Basically, it refers to the probability of losing the value of a stock or any investment because of negligence, rivalry with other stocks, and financial collapse. There are some businesses that are inclined to greater degrees of business risk. Some examples of these businesses include railroads, airlines, and similar industries.
The most effective resistance against business risk is the existence of franchise value. If a business has a franchise value, they are legally permitted to augment prices to make up for the increase in material cost, labor or taxes. A franchise value does not apply to any investment made under a commodity-type business and therefore, such an investment faces a substantial loss of value whenever the market’s financial atmosphere turns south.
I will make of use of examples to make it easier for you to understand the next investment risk type. For instance, I have recently located a company that totally made an impact to me. On the balance sheet, it has little or no debt, has excellent margins, its development is stellar and currently, it is getting bigger, with several new locations. However, the price I must pay to trade with this company is so far in excess of the amount of its present and average profits. Purchasing the stock is something I cannot justify.
The business risk is not the reason why I am worried. More accurately, it is the evaluation risk that bothers me. I can justify buying a stock at an exorbitant price, if and only if, I am completely certain that the development prospects in the future will augment my total profit yield to a better level than all the other investments in my control.
The fact that there is usually not much room for error in companies that seem overvalued is exactly the reason why there danger in investing in them. Such a business may appear superb, but if it goes through a significant decline in sales in even just one quarter or if it is not able to begin new locations as quickly as it initially predicted, the stock will experience a hefty decline. The question should never be “Is it wise to invest in this company?”, but “Is it wise to invest in this company at this price?”.
Now, let us discuss the last type of investment risk-the force-of-sale risk. Let us say that you have located a business that is performing outstandingly, with a trading price that is a lot lower than its actual worth, buying quite a few shares. It is now February and you intend to use the investment to fund for the payment you need for your tax bill on April. By doing so, you have committed a fatal mistake in the world of investing. There is nothing wrong with being somewhat certain of what is going to happen but there is absolutely something wrong with being pretty sure about WHEN something is going to happen. You must never guarantee yourself that what you think will happen will indeed happen on the time you think it will.
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