Thursday, 22 April 2010

The Risks of owning Common Stocks

The risk of investing is directly related to the uncertainty of the rate of return that you will earn.  The less certain the return, the greater the risk.  

The risk of an investment is especially great when there is a possibility that a large negative return (that is, a substantial loss) can result.  

Thus, common stocks are more risky than bonds, and bonds are more risky than savings accounts.  Insured certificates of deposit and U.S. Treasury bills, are considered to be virtually risk free because of the certainty of how much money will be received and when the receipt will occur.

Common stocks can be very risky investments to own for a number of reasons.  

1.  Nearly all common stocks subject investors to substantial uncertainty regarding the rate of return that will be earned.  Stock prices are extremely volatile, and it is not unusual for the market price of a common stock to move upward or downward by 30% or more during a year.

You might make the argument that you haven't actually lost 30% if you don't sell at the low price, but what if it goes lower?  In any case, for example, you paid $50 for an investment that is now worth only $35.  This represents a loss of your wealth regardless of whether you sell or keep the stock.

2.  The flow of dividend income from common stocks is often difficult to forecast because, unlike a bondholder's promised interest payments that are a legal obligation of the issuer, a company's board of directors must vote to approve dividend payments to the firm's stockholders.  In other words, common stockholders have no legal right to receive dividend payments.

  • The directors of a company that encounters financial difficulties may decide to reduce or even eliminate dividend payments to stockholders.  
  • Directors of a company may also decide to revise a firm's direction and reduce the dividend in order to increase the amount of money that is available for expansion.  
  • Even the directors of a successful company may not increase the dividends as much as investors expect.  
  • What a company may pay in dividends is much easier to estimate accurately in the near term than the long term, because it is difficult to forecast the business conditions a firm will face several years in the future.  New competition, new products, changing consumer preferences, and an uncertain economy all serve to make it difficult to forecast future corporate profits and dividends.

3.  A variety of factors can affect the return you will earn from holding shares of common stocks.

  • Unexpected inflation, rising interest rates, and deteriorating economic conditions can each be expected to have a negative impact on most common stock values.  
  • In addition, the shares of small, little-known companies may be difficult to sell without accepting a large price penalty.  
As investors discovered during the stock market meltdown of 2008, risk is an important issue to consider if you plan to invest in common stock.

No comments: