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.

Responding to risks: Minimising risks

If you choose to minimise a risk, you accept that it can't be eliminated, but take action to reduce its probability or negative impact (or both).  Minimising probability means taking actions so that a negative outcome is less likely to occur; minimising impact means taking actions so that the consequences will be less severe if a negative outcome does occur. 

We can see this in action by considering our own lifestyle choices.  By choosing a healthy diet and exercising well, we minimise the probability of health problems in later life.  By taking out health insurance, we hope to minimise the impact if they do occur.  Clearly, we could do both these things - minimising both probability and impact as a result.  How much action we take to minimise a risk, and the kind of actions we favour, depends on our own priorities, plus (as always) our assessment of probability and impact.  If our past medical history suggested we were more at risk from health problems, we might be more motivated to take action.

A parallel from business would be typical responses to operational risks.  Employees should be protected from physical harm wherever possible (minimising probability), but the employer is also obliged to have systems in place to deal with injuries should they occur (minimising impact).

Another example of minimising impact is double redundancy in computer systems.  Here an entire duplicate system is created and maintained, so that it can take over in the event of malfunction.  This hugely reduces the potential impact (though not the probability) of crucial data systems going offline; there is of course a trade-off in terms of cost.  This is often the case: in general, the more you reduce impact, the more cost is involved.  The business might choose to instate a repair contract with an IT service company instead, but this would not provide the same reduction of impact as the double-redundancy system.