Risks of Investing in Stocks and How to Avoid Them

Stocks can be one of the most powerful tools for building long-term wealth, but they can also expose investors to sudden losses, market swings and company-specific risks. Understanding where those risks come from, and how diversification, patience and a disciplined strategy can help manage them, can make it easier to invest with greater confidence.

A financial advisor can help you create a financial plan based on your risk tolerance.

Understanding the Risks of Investing in the Stock Market

Many Americans invest in the stock market, but not all of them understand the risks involved. Here’s a breakdown of six common types of risk that could affect your investments:

• Business risk: Business risk refers to the level of uncertainty and potential financial loss that is associated with investing in a specific company’s stock or equity. This risk can include underperforming earnings reports that are due to changes in leadership, quality management, competitive positioning, industry conditions and financial stability. 

• Downside risk: Downside risk estimates the potential decline in value for investments like stocks, bonds and other assets due to market-related factors and fluctuations. Changes in supply and demand, economic conditions, investor sentiments, company-specific events and broader market trends are considered downside risks. One example of a downside risk can come from holding a large position in a high-risk sector. If this sector experiences a market-wide downturn, the value of the holding will decline significantly.

• Economic risk: Economic risk refers to the potential of financial losses or reduced returns stemming from macroeconomic factors and events that affect the broader economy, financial markets and investments. One example of economic risk could come from a recession as it can affect a company’s sales and profitability, which could consequently lead to a decline in its stock price. Other examples of economic risk include interest rates, currency fluctuations and geopolitical events. 

• Inflationary risk: Inflationary risk can undermine the real value of investment returns and the purchasing power of investors. It refers specifically to the risk of inflation outpacing the returns of investments, which causes a decrease in the actual (inflation-adjusted) value of assets over time. Inflationary risk can have a substantial impact on fixed-income investments like bonds, as well as cash holdings and other assets that fail to provide adequate protection against the erosion of value caused by increasing prices.

• Political risk: Political risk refers to the negative impact on investments due to political events, instability or policy changes in a specific country or region. Changes in government leadership, shifts in political ideologies, regulatory modifications, trade disputes and geopolitical conflicts are considered political risks. One example of a political risk can stem from the sudden imposition of trade tariffs by a government, which can disrupt global supply chains and negatively affect the stock prices of companies reliant on international trade.

• Risk of being too conservative: Being risk-averse makes sense when you want to protect your portfolio. But a conservative asset allocation can also put your long-term investments at risk. Investors who are too conservative can fall short of their objectives, especially when higher returns from riskier assets like equities are needed to reach retirement savings or wealth growth goals over extended investment horizons. Investing the majority of your portfolio in low-risk, low-return assets like cash, bonds or stable dividend stocks can also fail to protect against economic risks like inflation.

Benefits of Investing in Stocks

Stocks can offer investors significant long-term growth potential by providing ownership in publicly traded companies. When a company grows its revenue and profits, its stock price may increase, allowing shareholders to benefit from capital appreciation. Historically, stocks have generally offered higher long-term return potential than more conservative investments such as bonds and cash, although they also come with greater volatility.

Some stocks can also generate income through dividends. Companies that pay dividends distribute a portion of their earnings to shareholders, providing investors with cash that can be spent or reinvested to purchase additional shares. Reinvesting dividends can contribute to compounding and potentially increase long-term portfolio growth.

Stocks can also help investors diversify their portfolios. Investors can spread money across different companies, industries, geographic regions and company sizes, which can reduce the impact that poor performance from a single investment has on the overall portfolio. Mutual funds and exchange-traded funds can make this diversification easier by providing exposure to many stocks through a single investment.

Another advantage is liquidity. Shares of most publicly traded companies can generally be bought and sold quickly during market hours, giving investors greater flexibility than less-liquid assets such as real estate. Stocks can also serve a range of financial goals, from building retirement savings over several decades to generating dividend income, depending on an investor’s strategy, time horizon and tolerance for risk.

Tips for Long-Term Stock Investing

Long-term stock investing generally works best when investors focus on consistency, diversification and their financial goals rather than short-term market movements. Because stock prices can fluctuate significantly over shorter periods, maintaining a long time horizon can give investments more opportunity to recover from downturns and benefit from compounding growth.

Diversifying across companies, industries and geographic markets can help reduce the impact of poor performance from any single investment. Investors who do not want to select individual stocks may use broad-market mutual funds or exchange-traded funds to gain exposure to many companies at once.

Regular contributions can also support a long-term strategy. Investing a set amount on a recurring basis, often called dollar-cost averaging, can help investors avoid trying to predict the best time to enter the market. It can also make it easier to continue investing during periods of volatility.

Investors should also pay attention to fees, taxes and portfolio allocation. Lower investment costs can leave more money available to compound over time, while tax-advantaged accounts such as 401(k)s and IRAs may provide additional benefits. Periodic rebalancing can help keep a portfolio aligned with an investor’s desired mix of stocks, bonds and other assets.

Finally, long-term investors may benefit from avoiding emotional decisions during market declines. Reviewing investments periodically instead of reacting to daily price changes can help keep the focus on long-term objectives, risk tolerance and whether the underlying reasons for owning an investment have changed.

Bottom Line

Stocks can offer long-term growth, income and diversification, but they also come with market, company-specific and economic risks. Investors can reduce some of those risks by diversifying, maintaining a long time horizon, investing consistently and avoiding emotional decisions during periods of volatility. A disciplined strategy can help investors pursue growth while keeping portfolio risk aligned with their financial goals.

Investing Tips for Beginners

• If you want to grow your investment portfolio and protect your money from risk, a financial advisor can help you create a financial plan for your needs and goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

• SmartAsset’s asset allocation calculator can help you figure out the allocation that makes the most sense for your retirement portfolio.

Photo credit: ©iStock.com/recep-bg, ©iStock.com/gpointstudio, ©iStock.com/ , ©iStock.com/mdphoto16