Smart investing entails knowing how to manage the probable risks. For every mutual fund, bond, stock, or any further investment you buy, there are 3 discrete risks you must safeguard against. These three types of investment risk are business risk, evaluation risk, and force-of-sale risk. You can find out about all of these types of risk from stock books or by reading on. The investing in stocks can be tricky so make sure your trading software 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. Examples of these industries include airlines, railroads, and the like.
Having a franchise value is the best defense against business risk. 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.
To help you understand more easily the second type of investment risk, I will be using examples. Let us say that just recently, I have come across a company that I was completely impressed with. 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. In spite of this, this company trades at a price that is way above its present and average earnings.I cannot find a good reason why I should buy the stock.
The business risk is not what I am worried about. Rather, I am concerned about the evaluation risk. In order to validate purchasing a stock at this excessive price, I must be 100% sure that the growth probabilities in the future will increase the amount of my earnings to a more desirable degree than all of the other investments I have.
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?”.
At this point, let us talk about force-of-sale risk, the last type of investment 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. It is okay to be relatively sure of what is going to happen, but it is never okay to be relatively sure of WHEN it 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.