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Equity Risks

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There are a wide variety of potential equity risks that can occur within the markets, some derived from the market, others from firms, government, or economics. You should be aware of all of these. These equity risks are Share Specific Risk, Share Liquidity Risk, Market Risk, Inflation Risk, Credit Liquidity Risk, Political Risk, and Currency Risk. These equity risks are separate from the risk of share depreciation, which is constantly encountered throughout the trading day.

Share Specific

Share Specific Risk occurs due to a firm’s strategy, financial, or management failures. This share is isolated to the firm itself, a business misplay due to operator error. You can reduce your openness to share specific risk by investing in several firms in a market, and not investing heavily into a single firm. This way, if one firm blows itself up, it’s only a small section of your overall holdings. You can also invest in funds, which engage multiple markets. The last way to avoid share specific risks is to analyze the firm’s fundamentals, and actively review news associated with the firms. You can exit an investment before it goes bad if you are aware of weaknesses.

Share Liquidity

Risks of short supplies also exist with equities. This risk is called “Share Liquidity Risk”. This is the risk of shares you want to purchase, or sell, becoming illiquid. If you are selling liquidity risk is a lack of buyers, if you are buying liquidity risk is a lack of sellers. If share trades can only be made at an unfavorable price due to shortages, it is still categorized as share liquidity risk. This risk typically only exists at lower capitalization levels. Firms with substantial amounts of shares, large capitalization or mega-capitalization firms, rarely ever suffer share liquidity problems. Even with a large amount of market matchmakers, these issues can still occur, but usually only occur at unfavorable prices. Your trade will normally still take place.

Market Risk

Market Risk is similar to share specific risk, but extends across the entire market. Market risk is the risk of an entire economic market crashing. This is the chance of being invested during a bear market and experiencing substantial value loss across a set of shares. You can counter market risk in several ways. The first way to counteract market risk is to invest in a variety of assets. By selecting bonds, cash, commodities, short sales, and alternative investment instruments, you can limit your susceptibility to a market crash. You can also invest internationally. By investing in multiple foreign markets you reduce your possibility of market losses from one area. Some markets are highly interconnected and may crash if another market crashes, creating a chain effect. Avoid this by investing some of your portfolio in middle or small capital foreign investment funds. These funds have low correlations to crashes in developed markets. Lastly, you can invest a small percentage of their available assets at a time, slowly investing your total asset pool over years as opposed to a single lump sum. By using this method to invest you reduce your chances of investing all of your assets immediately before a market crash. You also raise your chances of investing your money when prices for shares are very low. Your purchases are spread across a range for generating returns. In exchange, you may miss early bull markets or invest limited amounts money at the markets top. This is preferable to investing all of your money at the markets peak and suffering large losses.

Inflationary Risk

The risk of an investment being outpaced by inflation is known as “Inflationary Risk”. If inflation (the increase in prices which erodes purchasing power over time) outpaces investments a shareholder is slowly losing their ability to purchase an equal number of goods. This becomes a substantial problem if you face a negative return for an extended period of time, you will have lost both money and accelerated the erosion of purchasing power. If you are successful you will both earn positive financial returns and exceed the rate of inflation, which implies you are gaining purchasing power over your investment time period. Inflation typically increases at a rate between three and four percentage points annually. Shares have historically earned between six and ten percentage points. However, in portfolios with extremely low capital appreciation over time, inflation can outpace your returns.

Credit Liquidity

Credit Liquidity Risk is usually a share or market specific problem which occurs when there is a credit crisis within a nation, market, or region. A credit crisis occurs when lenders, banks, and investors simply have no desire to loan money to firms who need shot term credit to pay their bills. Short term credit is essential to firms, the ability to borrow short term loans allows them to pay their payroll, bills, and other expenses until accounts receivables are paid in full. After accounts receivable is paid in full, the firm can repay the loans. If firms cannot receive a loan, and lacks the reserves to pay their bills, a crisis may result which substantially hinders business ability. The firm may go bankrupt due to a lack of capital. This typically happens in emerging markets, but has occurred in developed markets under extreme circumstances, such as 2008’s subprime loan crisis.

Currency Risk

The chance that a firm’s currency will become destabilized or highly volatile is known as currency risk. When a currency’s value becomes destabilized, prices change rapidly, typically moving upwards. Currency for a firm’s native market will become devalued in international trading, resulting in increasing difficulty for the firm to function. Supplies, technologies, services, and labor costs which are imported will increase in price. Earnings for exported products will simultaneously decrease. Imported expenses slowly erase exported profits for the firm, unless exporters raise prices to compensate or charge for static amounts in foreign currencies. Foreign investors will typically abandon firms in the domestic region, and shareholders who continue to retain their investments suffer increased losses.

Political Risk

Political Risk is the risk of government intrusion into a business’s ability to operate. The disruption of a firm affects the shareholder’s investment and reduces the value of their shares. This refers to any potential political policy or action which disrupts business, and a wide spectrum of actions can occur. This typically includes increased regulations, increased taxation, revocation of subsidies or licenses, denial of operational rights, fines, and property seizure. In the case of complete mayhem, this can also include invasions, revolutions, insurrections, strikes, overthrows, coup d’états, and civil wars. These occurrences are typically accompanied by investors abandoning the shares affected, shares of similar firms within that marketplace, and occasionally the entire region affected for more stable investments. This movement is known as a “quality flight”. Extreme political risks may be accompanied by market risk, credit liquidity risk, share illiquidity, and currency risk. These are all due to investors concerned about the length of political uncertainty within the market during political fallouts and power vacuums.

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