Investment Shastra

What are the Different Risks at the Stock-level?

The Rule No. 1 of Investing is, ‘Never lose money.’ And, the Rule No. 2 is, ‘Never forget rule No. 1.’ – Warren Buffett

Your Stocks portfolio can have 7 types of risks:

(A) At Stock-level: 1. Business Risk, 2. Valuation Risk and 3. Liquidity Risk
(B) At Portfolio-level: 1. Asset Allocation Risk, 2. Market Cap Risk, 3. Sector Exposure, and 4. Stock Exposure
Some risks help you earn good risk-adjusted returns, you need to manage them. Eliminate the rest!

Let’s understand the risks at the Stock-level

1. Business Risk:

Companies with poor fundamentals and weak business models are unable to deliver consistent and sustainable profitable growth. The company’s poor performance could be the result of low or no sales growth, poor margins, inefficient management, inefficient capital allocation, etc. Investing in such stocks exposes your portfolio to the Business Risk.

In the short term, it is possible that even substandard business gives temporary returns. But in the long term, a company’s performance is reflected in its stock returns. As rightly said by Benjamin Graham, the father of Value Investing,

“In the short term the market behaves like a voting machine, but in the long term it acts like a weighing machine.” 

Even large or prominent companies are not immune to business risk. Investing in companies with business risk means you run the risk of losing value from falling prices. The returns generated by buying healthy companies can be wiped out because of such bad investments.

What kind of business should you invest in? Invest in a business that behaves like a compounding machine; companies that perform consistently and have sustainable earning power. Such performance will translate into higher market values and earn you compounded returns.

2. Valuation Risk:

When a stock is over-priced compared to its fair value, your portfolio is exposed to Valuation Risk. It impacts return on investment, as the more over-valued the asset is, the lower the probability of returns for the investor. Over-valuation is usually a temporary phenomenon. Sooner or later, due to self-correcting mechanism, the price of such stocks fall, either gradually or often with a dramatic crash. If you have overpriced stocks, forming a large portion of your portfolio, the price- reduction will decrease value of your portfolio, even if the correction is only to its Fair Value.

Don’t believe the myth that you can time the market, sell at the highest price or get out at the peak. If you have access to the Fair Value of the company with MoneyWorks4me’s Superstars plan, compare it with the stock’s current market price. This will help you gauge where the stock stands from a valuation perspective. To continue to earn good returns and avoid valuation risk, it is safer to,

  • Sell over valued stock and book profits, at least partially, and
  • Invest in fundamentally strong companies at attractive prices

3. Liquidity Risk:

When an asset has low trading volumes and does not have many buyers in the market, you cannot sell stock quickly. It exposes you to the Liquidity Risk. In such case, you will only be able to sell large quantities of your stock(s) at rapidly decreasing prices. This is evident for small companies that have a small free-float, or any company in which a significant portion of issued shares are held by promoters, government, strategic partners, etc. and not traded in reasonably large volumes regularly.

If an asset is carrying the Liquidity Risk without other risks, you should start selling gradually. However, if the stock is exposed to the Liquidity Risk accompanied by other risks too, your risk is compounded.  It is better to exit such stocks immediately.

You can identify these Stock-level risks in your portfolio real-time, and get recommended actions to reduce them at a click of the button, with our Portfolio Manager, for free! Just register and upload your portfolio.

Also Read: ‘What are the risks at the Portfolio-level?’

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A team of business leaders, equity research analysts & investment counsellors. Started in 2008; experienced in equity research, financial planning and portfolio management. Passionate about providing institutional quality research and advice to Retail Investors in a simple easy-to-understand-and-act manner.