3 Risks You Need to Know Before Investing in Stocks

• Level: For Advanced
• Reading duration: 4 minutes

You can make good profits by investing in the stock market – at least the average annual return of the S&P 500 Index since 1957 is 10.3%. Nevertheless, there are no risk-free investments. And the higher the return, the greater the risk.

1. Market risk

Market risk is one of the main risks to which you are exposed as an investor. It refers to the fact that the value of shares is influenced by general fluctuations on the financial market. These fluctuations are triggered by various factors, including

• Global economic events: News about economic growth, inflation, interest rates, employment figures and other macroeconomic indicators can affect investor sentiment and consequently share prices
• Fiscal and monetary policy: Decisions by governments and central banks regarding fiscal and monetary policy, such as interest rate changes, can also have a significant impact on equity markets
• Changes in market conditions: Factors such as liquidity, volatility and investor confidence can affect share prices. For example, a volatile market can lead to unpredictable price movements
• Geopolitical events: International conflicts, trade tensions, political elections and instability can trigger uncertainty in the financial markets and drag down share prices
• Technological change and innovation: New technologies and innovations can influence investors' expectations regarding the future prospects of companies and therefore the value of their shares

One thing is for sure: Risks are always uncomfortable. However, it is precisely because of these risks and fluctuations that the expected return on the stock market is higher than with less risky investments. In addition to the risks mentioned, there are a few more. At the end of the article, we will show you how you can deal with them and what options there are to manage them cleverly.

2. Sector or country risk

Sector or country risk is the risk associated with a particular sector or country in which a company operates. By investing in shares in a particular sector or country, you automatically expose yourself to the specific risks of that sector or country. Different sectors can react differently to macroeconomic changes and economic cycles. Sectors such as technology and cyclical consumer goods, for example, are more sensitive to changes in economic growth than sectors such as food and consumer staples, which tend to be less cyclical. An example of this is investing in leading technology companies such as Apple. The technology sector is characterised by rapid change and innovation. One risk is that companies in this sector are unable to keep pace with technological developments and lose their competitiveness as a result. Another example is a manufacturer of renewable energies in an emerging country such as Brazil, which can be affected by political instability or internal political conflicts.

3. Exchange rate risk

If you invest in foreign shares, you are also exposed to exchange rate risk. Exchange rate fluctuations can affect your returns depending on the development of the exchange rate between the euro and the foreign currency. For example, if you decide to invest in shares in a US company such as Microsoft, you may be exposed to currency risk. Imagine the euro is worth $1.10 at the start of your investment. You buy Microsoft shares for a total of €10,000 and receive the equivalent of $11,000. If the US dollar appreciates against the euro over time, you will receive fewer euros for the same dollar amount when you sell your shares – this can lead to losses.

How can these risks be minimised?

One proven method is to diversify your portfolio. This means: Don't concentrate your money on just a few stocks, but spread it across several stocks and asset classes to reduce your overall risk. Diversification can be achieved through various strategies, including

1. Asset allocation: Spread your money across different asset classes such as shares, bonds, investment funds, property or commodities
2. Sector diversification: Invest in different industries to reduce sector-specific risks
3. Geographical diversification: Invest in different countries or geographical regions to minimise regional risks
4. Diversification between high-risk and low-risk investments: Pay attention to the balance between high-risk investments such as equities and low-risk investments such as bonds

You can eliminate almost all "unsystematic" risks through diversification.

• Unsystematic risks are things like individual value risk or management errors that can lead to a company's imbalance or bankruptcy
• Systematic risks – i.e. the risk associated with an asset class - cannot be completely eliminated

This is because when investing in equity ETFs, at least the systematic market risk remains, which is characterised by higher volatility, among other things. However, as long as you are aware of the existing risks and know how to cleverly avoid or limit them, there is hardly anything standing in the way of your stock market success.