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What are the risks of investing in joint stock companies?

What are the risks of investing in joint stock companies?

created Natalia BojkoSEPTEMBER 21, 2022

The greater the risk, the greater the potential profit. I think this principle is known to most investors. It can be said that as the potential earnings increase, the risk we take increases proportionally. Do you actually invest in any corporate securities is there a "catch" in the form of excessive risk?

In my opinion, people who are already taking a step towards potentially investing capital in shares were looking for an answer to the question - how much can I lose on it? Therefore, it is worth learning to recognize and estimate your chances that our investment will not result in a loss. Along with knowledge, there will also be methods of skilful risk assessment to minimize them in your investments.

The appetite grows with… earnings

In nature, as you know, nothing is lost and nothing is for free. If we want to earn more, we should learn to tolerate and accept risk. Then slowly get used to the possible losses, which in this case are a measure of our error. One of the best features of a good (earning) trader is the ability to manage risk. In order to obtain it, one should start with the risk to which we are exposed when investing our capital in the securities of companies. Later, they need to be understood and incorporated into the strategy we are using.

The company's financial and operational risk

Simply put, this type of risk tells us that the company we have invested in will not generate profits. In very extreme cases, it may suspend operations, record a large loss or declare bankruptcy. Taking a closer look at the purely financial risk, it is related, as the name suggests, with the financing of the company's current and future operations.

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The enterprise's entire line of credit will be here. The second, operational, concerns the company's economic activity, i.e. sales, production or employees. Simply put, these are factors whose lack or a strong decline may disrupt the company's current operation (i.e. reduce potential earnings).

How to defend yourself against it? In order to find out about the company's financial condition, margins and their prospects for the coming months, it is worth taking a thorough analysis before starting the investment. By entrusting your capital to an enterprise with good foundations and healthy financing, we significantly increase the chance of protecting ourselves against an unsuccessful and loss-making investment.

Interest rate risk

Not every potential investor received detailed economic education during his studies or high school. However, everyone should be familiar with and broaden their knowledge in this area, as it is one of the key factors that affects our potential profits. In Poland interest rates are determined by the National Bank of Poland (central bank). He is responsible for setting the level of 4 different interest rates: rediscounting of bills of exchange, lombard, deposit and reference loans. The latter affects the financial markets the most. Its operation is most visible on the bond market.

Nevertheless, actions cannot feel completely safe and free from its influence. Why? There are at least a couple of reasons. The first is the customers themselves. An enterprise with substantial cash receipts is one that has buyers for its goods. Increasing interest rates means higher interest on loans. Hence? Companies producing goods whose payments are often split into installments may lose some customers for whom even this option proves to be too expensive.

The situation of a company that has short and long-term liabilities itself is very similar. This means that it will pay higher interest on the money you borrow. Higher interest equates to higher financial costsand these, in turn, affect the profit of the individual.

In order to become somewhat immune to interest rate fluctuations, it is worth having various financial instruments in your portfolio that will perform well in the period of low or high interest rates. Of course, we do not encourage excessive diversification by force, but a rational purchase of profitable instruments that will generate profit in the short term.

Inflation risk

Inflation is nothing more than a loss of the purchasing power of money. Put simply, it means that over time, for the same amount, we will be able to buy fewer goods than before. A safe and stable inflation level is somewhere around 2%. We then say that the prices of goods and services increase by 2%. How does this economic factor affect our investment?

Primarily high inflation can eat up some of our real investment returns. Suppose we bought bonds that guarantee us a profit of 6% per annum, while inflation is at 7%. Despite earning (e.g. for PLN 100 for one bond), e.g. PLN 6, our PLN 100 lost 7 PLN in value during the year.

READ NECESSARY: Hyperinflation - the death of money

The second part of the inflationary risk is based on the actions of the central bank. By setting the level of interest rates, the NBP is able to keep inflation at the appropriate levels. Here, however, I refer to the chapter above.

Tax risk

This type of risk affects our investment quite specifically. It does not raise the share price, but it effectively reduces the amount of income that we get from selling them. Possible changes in the tax system necessarily affect the amount of profits we achieve. It is important to understand capital gains taxes, because selling or buying securities at the wrong time can put you at risk of unnecessarily depleting your potential earnings.

Political risk

It is one of the most unpredictable types of risk, from which it is difficult to completely protect yourself. Politics has a huge impact on most things that surround us, including listed companies, the tax system and the economy. Laws and the law shape the environment in which companies operate. It often determines the development of companies in which we want to invest, creating dynamic conditions for their expansion.

Currency risk

The risk mainly concerns investors who try their hand at foreign markets. We are talking about investing in a foreign currency. We are naturally exposed to changes in the exchange rates of individual currencies. In such cases, the risk of investing capital in a specific instrument doubles. This is because not only the valuation of shares changes, but also the exchange rates of foreign currency into domestic one. Of course, the quotes can go to our advantage, but nevertheless it is a volatile market which, with a greater involvement of cash, can significantly reduce our earnings.

Suppose an investor intends to buy American shares on the NYSE (New York Stock Exchange). He conducted a thorough financial analysis and decided to buy a company whose securities cost USD 10,00 per share, and for USD we have to pay (rounded up) PLN 4,90. Therefore, one share of this enterprise costs the investor PLN 49,00. Suppose an investment yielded a 20% rate of return ($ 12 per share) and the dollar fell from 4,90 to 4,60. However, the shares held by our investor are worth PLN 4,6 (converted into PLN, at the exchange rate of 55,20). As a result, our 20% equity gain, at an unfavorable exchange rate, nearly halved to just under 13% (12,65%).

The companies themselves are also burdened with currency risk. Therefore, it is worth knowing the specification of the type of activity of a given enterprise. Firms that experience adverse fluctuations in exchange rates are primarily those whose large part of activity is focused on the import or export of goods or services. Strengthening of the domestic currency may worsen the results of exporters, while importers reduce costs.

Stock market risk

The stock market is a place where the interests of individual investors are pursued. As a collection of different personalities, characters, strategies and goals, each of them makes specific decisions about buying or selling securities. Regardless of whether they rely on their analyzes or the opinions and recommendations of friends or brokerage houses, they create masses of demand or supply for specific securities. Given the multitude of factors that determine their choices, it is difficult to define and predict their behavior in the short term. Nevertheless, it is the demand and supply that determine whether our investment will bring us the expected return. Short-term stock market play is more risky in terms of market risk than long-term investments.

Raw material price risk

Some companies (especially industrial ones - metalworking, etc.) are exposed to the risk related to the raw materials they use, for example, for production. Commodities themselves do not constitute separate instruments on the WSE, but their prices directly affect the results of specific companies. KGHM is a good example of a company that is strongly correlated with the commodity markets. Price increases on copper market turned out to be beneficial for this company, which in the years of the highest increases in red metal, recorded an eightfold increase in its shares. Unfortunately, each stick has two ends, and therefore companies that are recipients of KGHM's products, including cable manufacturers, have suffered.

The increase in specific raw materials (in this case copper) contributed to the possibility of selling its products at higher prices, and thus, larger amounts of cash flowed into the cash register. The opposite situation happened to cable manufacturers, whose increase in parts for their production was associated with a much higher cost of manufacturing the goods.

Credit risk

The name itself can be misleading, but nevertheless, this category is not about taking out loans. This means that the company is likely to go bankrupt. This type of risk affects bond buyers rather than company stockholders, as the former shoulder the likelihood of losing their entire investment. The bond, as a debt security, is a loan to the enterprise from the investor, which the company has to repay. Shares carry a similar risk, as not only can they lose value, but also completely disappear from circulation in the event of bankruptcy.

In order to be able to minimize the credit risk of an investment, it is worth thoroughly analyzing the company's financial liquidity. Thanks to its assessment, we know whether the company is liquid and solvent enough to be able to pay off its liabilities in the coming years without major difficulties.

Liquidity risk

By liquidity, we do not mean the company's stock of money to run its business, but the liquidity associated with trading the company's securities on the stock exchange. Who shapes it? None other than investors. They decide which company they want to buy and which to sell. The number of people willing to enter into transactions on a particular value determines the concept of liquidity.

In theory, both the demand and the supply are limitless. In practice, when the average daily turnover (how many shares were exchanged - bought / sold) is 4, and we are going to buy 000, we may have a problem with the price of the stock being too high and the security's accumulating time being longer. When deciding to get rid of them from your portfolio, a situation may arise in which there will be few buyers willing to buy shares from us.

Personal and emotional risk

I have deliberately left the last two types of risk for the end, due to the fact that the probability of investment failure does not always have to come from the stock exchange and the broadly understood market. It may simply result from the personal situation of the investor, which induces him to make unreasonable or unfavorable decisions. Rapid cash can force us to sell our stocks quickly, at unsatisfactory prices, or those that will not bring us any profit, and even worse, will generate losses.

Emotional risk is different from personal risk. Here, as the name suggests, emotions play the first fiddle that disrupts rational investment decisions. Hence, we can often observe enthusiastic or panic exit of large masses of investors from the market. Surrendering to them is one of the key problems not only for a beginner investor.

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About the Author
Natalia Bojko
Graduate of the Faculty of Economics and Finance, University of Białystok. He has been actively trading on the currency and stock markets since 2016. It assumes that the simplest analyzes bring the best results. Supporter of swing trading. When selecting companies for the portfolio, he is guided by the idea of ​​investing in value. Since 2019, he has held the title of financial analyst. Currently, he is the co-CEO & Founder in the Czech proptrading company SpiceProp. Co-creator of the Podlasie Stock Exchange Academy project (XNUMXrd and XNUMXth edition).