WHAT ARE THE RISKS OF INVESTING IN THE STOCKS?

“Risk comes from not knowing what you’re doing.”

Now you are aware of how people make or lose money in the Indian stock market. We have also discussed certain visible risks like market crash which leads to investors losing their money.

Similarly, if anyone sector crashes, investors who have concentrated their investments only in that particular sector also lose money. Now let’s look into those specific risks which basically impact the market and the whole sector itself. For that, we should know, what are the different types of risks one business can face? Investing in the stock market is nothing but investing in businesses. And you know that there is market risk, industrial risk, and sector-specific risk. 

What are those stock-specific risks you need to be aware of?

Whether you will be able to manage them or not is a secondary factor, but for me, it was important to make you aware of it. First, let me explain to you on a theoretical basis about what kind of risks can a business or company faces. They are as follows, 

 COMMODITY PRICE RISK 

You all have heard about the crude oil. There are companies that produce them and there are others that refine crude and convert them into final products like petrol, diesel, etc. and then there are companies that market them as distributors. 

CAIRN energy in India is crude manufacturers. They produce crude by going onshore.  Reliance industries refine this crude and convert it into final production. And you have companies like BPCL, HPCL, and Indian oil that distribute these oil and make income. So these are the oil marketing companies. 

Then there are companies that are dependent on oil prices. Let’s say the paint industry. One of the important components of paint is the petroleum product. So if the prices of the petroleum product go high then the profitability of the paint companies will come down.  

Consider from the perspective of an oil manufacturing company. If the oil prices increase they will be profitable. For the companies who are taking this as raw material, the price hikes become a risk. Companies for whom it’s final product may also become risk once the prices fall from a certain threshold. 

Now you must be thinking about other companies that are not dependent on this price fluctuation of most of the commodities that we use??? If one commodity price goes higher more chances of other commodity prices to rise too. Am I right? 

In the same example of petroleum products let’s say in India most of the transportation happens via trucks, now if the petroleum prices are going high, it impacts the transportation charges, in return every other commodity price also will affect. Then we tell it as the economy is little sluggish. It can actually impact the whole economy if all together many commodity prices increases. 

A lot of companies face this commodity risk for sure. Even if you have invested into a petroleum company [final produce] or if you have invested into a paint company [as raw material], in both the cases you have to keep checking the price of the petrol. Similarly, other commodities also impact the economy, which in turn affects the different company performance. 

  HEADLINE RISK 

We all know that we have a dependency on the US market, mainly the services sector, and are aware of the 2007 US Subprime mortgage crisis. Because of the crisis, businesses in INDIA did not stop! but it got affected to a certain extent. The distress environment which was created because of the news headlines of the subprime crisis impacted our market a little badly. There were problems in INDIA but not as much as the US. 

These headline risks are on the economy level and also on a certain sector/ company level. Sometimes there would be absolutely no issue with the company but still, it may come in the headlines and rumors can make the company’s stock prices go down for a short period. And the company will end up facing many issues. So without doing anything wrong a company can get into a mess because of headline risk. 

So you should be able to identify the right and wrong news about the company you have invested in. So in general we cannot deny the fact that headline risk does affect the stock prices. 

  RATING RISK 

Credit ratings are the ratings given by the credit agencies. Companies that have issued stocks to raise funds also choose debt as a mode of finance. Let’s say you got a good credit rating, and then the benefit is you will get cheaper loans. When a company has to do business they raise money either in the form of debt or equity, debt is nothing but a loan.

Loans come in different rates of interest. When you take an example of your own life, housing loans come at 8% to 8.5%, but if you take personal loans its 14% interest rate. The risk in housing loans is very less because house prices will not go down or house is kept as collateral against the loan. A personal loan has no collateral so it comes in 13% to 14% interest rate. 

But when credit agencies downgrade the ratings of those companies, think what may happen? The problem arises from people who have to lend them money and ask them to increase the interest rate and new financing will also happen at higher rate. Now if you are getting loans at a higher rate than the earlier rate, then it will surely affect your profitability. 

Because whatever the profits you make you will be giving a portion of it as an interest. A lot of companies like steel companies, etc has experienced this. Where the companies ratings went down and their loan became expensive and they were not able to pay their interest and many shareholders were in loss. 

So credit ratings are one of the important ratings for financing the business and this risk is also always there. Within the rating section, there is another rating that is given to the companies or the rating of the share prices by the rating analysts. Sometimes yes, even if it’s malpractice like they had certain differences and not very much optimistic about certain companies, then chances like a group of rating analysts can give bad reviews for a certain period and the stock prices of that particular company can fall. 

This kind of rating impacts the stock price for sure. You have to keep watching what is the rating given by the majority of good fund houses, also what is the rating being given by the credit rating of the company. Credit is very important, which is one of the modes of financing. Financing has to be cheaper and it will available so only if we have a good credit rating. 

OBSOLESCENCE RISK

It’s more of a philosophical risk like there is no such thing that companies will always exist. Anything can happen in the long run like it may get competition from others or business models may go obsolete. If you take an example of the fortune 500 companies that were there in the world 30 years back, you will find that hardly a few names will be on the list now. 

So every 10 to 15 years businesses change, models change. If you look at INDIA these days, we are so much dependent on companies like Amazon, flip kart, etc... If you check 10 years back it was different companies we were dependent on. 

So the point here is philosophically people think that one or other day business model will change. For example like NOKIA phones, were the players in the market. Everyone had those phones then. But once the APPLE and other android phones were launched, that company went through a bad phase, their shareholders lost a lot of money. 

So you have to keep watching that you are exposed to futuristic companies and realize the eternal truth that nothing is going to survive always and it applies to all companies. Since the company is in the market for very long it does not mean that it will be good. But here in India, we have many such good companies like the TATA group, Reliance group, BIRLA group, etc… 

If you compare the BIRLA group and TATA here, they haven’t grown as Tata had grown. They were contemporary when the country got freedom and they were the two business houses from then and still, you find many companies that are performing better than BIRLA. So you have to visualize more of futuristic companies. 

  DETECTION RISK 

If you remember 10 years back we had a big case of Sathyam. They were one of the top 5 Indian IT companies back then. Right now it’s taken over by Mahindra group. The case with Sathyam was their promoters themselves were involved in siphoning the money; there is much conspiracy news around. 

Their reputed auditors were fined for their mistake. Even after doing all the measures, detection of something like a fraud happens very late. And by the time it’s revealed, people won’t even get a chance to come out of their stock. And there will be only sellers in the market and nobody wants to buy such a company with such fraud issue, where promoters themselves are siphoning the money and auditors are not able to detect it from years. 

Even if the company has been audited by the best of the auditors and they are in the market for the last 15 to 20 years, malpractice can happen with the company which cannot be detected on time. How to manage it is covered as a separate module as RISK MANAGEMENT in my course on the Indian Stock Market. 

So detection risk is more to do with the detection of fraud or issues which were supposed to happen during the audits, but it did not come out in time and by the time it was found, it would have done too much damage. So this risk too will always be there. 

LEGISLATIVE RISK

Companies face different types of risks when the government keeps changing the rules. Now consider oil marketing companies. Think government tells them that whatever oil you are selling you can keep 4% profit on that. And later if they think that oil prices are getting high they will ask the companies to reduce the profit percentage to 2% and sell it to consumers as they feel it's impacting the economy as a whole. 

Then oil companies have to obey the government as it has a great influence on companies. The government can dictate as well in certain sectors. This kind of risk can happen overnight to companies and make an impact on the company. 

  INFLATIONARY RISK

Inflation is a sustained increase in the general price level in an economy or the hike in the prices of the entire commodity which a common man consumes. What happens when inflation is high? 

To curb inflation, RBI increases the interest rate of the commodities. Once this happens the liquidity suck outs from the economy and the inflation comes down. People stop consuming the earlier amount they were consuming in the normal days. 

Inflation is one thing that certainly impacts the stock market. If you have high inflation, the interest rate has to go high to curb inflation. Now, this results in the mode of financing are expensive. It will impact the companies who have raised money through the debt market. Even for a company like reliance which is the largest in our country, they have huge debts, you can check out more details on the screener website. 

In some cases there are companies that have not taken any debt like Infosys, TCS, so for them it won’t have any impact. But for the companies which have huge debt and the debt-equity ratio is really high then it will impact like anything. If inflation is low probably people won’t be much bothered in increasing the interest rate. 

  MODEL RISK

We have discussed obsolescence risk which was more philosophical. But the model risk is more of a practical side. Business models that have been running for a long time, as well as short time, can get reaccepted from the other models. 

Now like a company like KODAK who was very good at making cameras, dint revolutionize themselves with time into digital form and the whole business model collapsed. They dint put more effort to the research and development so that they can come up with a digital camera and the whole business model would have changed. 

There are many other examples of where the model of the business itself got changed and the company did not even get a chance to react to that change. So the point here is model risk is also there. A business that is working from the last 4 to 5 years can one fine day just fail. 

Now in these theoretical aspects, we saw various factors that affect as critical risks for the company. Out of these risks I had discussed till now, it may be possible that the company which you have selected will have only 4 to 5 risks. But the idea is when you have heard about these kinds of factors you will be more confident every time you want to buy a share, about the risks involved with that particular sector in advance. Like if you want to buy a petrochemical company share, you will know that these are the 3 or 4 factors that I need to keep a watch on… 

So knowing the risk in advance is very important and you should understand it more from a business perspective. Why a small risk or even a small change in profitability can disrupt the stock price in the short term? 

For that I want you all to check the compound interest calculator. Calculate the value of the company at a stock price of 100RS per share at 16% growth with 100crores profit per year and the same company with just a drop in 25% profit that is 75crores which will become growth rate of 12% per year for 30 years invested. Yes! You all can see the huge difference in the compounded stock price rate. 

You would wonder that the company is still profitable and they have posted good profit and even then why the company’s stock prices have gone down? So they go down drastically even after a single percent change is because market participants had invested in the future value of the company. And the future value will keep on get compounded and they become really huge after 25 to 30 years on a higher rate than a slightly lower rate. This is the power of compounding. 

If this helps the company projects a good return in the next 20 to 30 years, the same way it impacts adversely when the profit or sales count drops. Sales may go up, but if the profit is coming down if the company had got exposed to anything like credit risk or rating risk, then the share prices can go drastically down in that quarter even by 20% to 30%.

Now you all know that,

At company level what are the different kind of risks which are there in the market?

How the power of compounding adversely affects these company’s stock prices in the current market price.

How a slight change in profit can result in up to 50% of the drop in the share price.

How a small risk can basically create a huge impact on the share price.

This topic is one of the classes from my course on the Indian Stock Market.The idea of the first 12 basic topics of the course is basically to give you a glimpse of the stock market. To make sure that you know about the basic concepts of inflation, different kinds of risks, businesses, power of compounding. I want you to make you all so familiar with these words that by the time we start working on real chapters, you will be able to understand better and correlate with what I am telling about.

My intention is not to make you fearful about the stock market, but just making you aware of all the possible risks to make you well prepared.

Most of the big companies always try to mitigate these kinds of risks and even if they are not able to do, with certain risk management practices you can mitigate some of these risks. Like by shorting nifty future you can control the market risk. By diversifying your portfolio into six to seven sectors you can mitigate the sector risk. And on the company wise risk, how to manage, we shall learn in the course.

If you are new to these blogs, I suggest you check out my other blogs on most basic queries on the Indian Stock Market which will help you build a strong base before you begin exploring,

1) Why does the stock market exist?

2) How does someone make money in the stock market?

3) Why do people lose money in the stock market?

4) Why does the stock market go up and down?

5) How to invest in the stock market without taking anyone's help?