• Experienced finance analyst reckons investors misunderstand equity risk or even ignore it at times
  • Equity risk refers to the uncertainty of returns or potential loss of your investment
  • There are five types of risk investors should be aware of and simple strategies to minimise losses

When investing in equity markets one of the most important considerations every investor must make is what are the risks of buying the stock?

Wealth Within chief analyst Dale Gillham, who has worked in finance for more than 30 years and been an analyst for 25, said the issue he often sees with investors is that equity risk is often misunderstood or even ignored at times.


What is exactly is equity risk?

In simple terms, Gillham said equity risk refers to the uncertainty of returns or the potential loss of your investment.

“When buying a share, investors often have an expected return, so the risk you take when you invest is that your investment’s actual return will be different from your expected return,” he said.

“We all know that investing in the stock market carries risk due to economic conditions, market volatility, and a company’s performance.

“The level of risk you take will vary with each stock you buy and the type of portfolio you construct so it’s important to be aware of the following types of risk that investors are facing.”


The five types of equity risk


1. Market risk

Gillham said market risk, also known as systemic risk, is important to understand as you cannot eliminate or diversify market risk, you can only have more or less of it.

“Market risk includes such factors as the risk of the economy, both local and world economies, government regulation and anything that might influence the financial system or market,” he said.

A good example of market risk is the consequences of global inflation on markets at the moment and consequent interest rate tightening by central banks.

The Reserve Bank of Australia for example yesterday raised the cash rate by 25bp to 3.35% in a bid to curb inflation, which shot to a 33-year high in the last quarter to 7.8% YoY, or 1.9% QoQ.

In it accompanying statement the RBA said the board’s priority is to return inflation to its 2-3% target with its comments about future hikes spooking the ASX and causing it to fall after the 2.30pm (AEDT) announcement.

“The Board expects that further increases in interest rates will be needed over the months ahead to ensure that inflation returns to target and that this period of high inflation is only temporary,” the statement said.


2. Specific risk

Gillham said specific risk is the risk of an investment falling in price.

“For example, if you have all your money invested in one stock, your specific risk is very high,” he said.

“Unlike market risk, specific risk can be diversified, but some investors over-diversify and, in doing so, end up taking on more risk than they realise.”


3. Liquidity risk

Gillham said liquidity risk is the risk that you will be unable to sell your investment or sell it at the desired price due to a lack of buyers or the difficulty of finding a buyer in a timely manner.

“Liquidity risk is pretty common with penny dreadful stocks that have low trading volumes and, therefore, are less liquid than other stocks,” he said.

“While the appeal of potentially high gains makes these stocks attractive, the lower liquidity with these penny dreadful stocks makes investing in them very high risk.”


4. Concentration risk

Gillham said it’s often said that concentrated portfolios are high risk and, to some extent, this is true. But he said what is a concentrated portfolio?

“If you invest all of your money in just a few stocks, then this would be considered a concentrated portfolio and may be considered high risk,” he said.

“This is why I always recommend that investors hold between 8 and 12 stocks in their portfolio.”


5. Counterparty risk

Gillham said this type of risk is often overlooked by investors as they are more focussed on the stocks they are buying and not who they’re dealing with to buy the stocks.

“Counterparty risk is the risk that the party you are investing with will deliver on what they promise or promote,” he said.

“For example, if you decide to purchase an ETF, you will buy it through a broker, but the actual counterparty risk lies with the underlying fund manager managing the ETF.

“That’s because you’re relying on the company who provides the ETF to not only follow the investment process they promote but that they remain in business and continue to deliver that ETF.”

He said while the risk with ETFs can be low, some investors choose to invest in other investments that promote higher returns and are far riskier, not only in terms of specific risk but also counterparty risk.


The bottom line on equity risk

Gillham said investors can manage equity risk by following some simple strategies, such as diversifying their portfolio, regularly reviewing their investments, and being aware of market trends and factors affecting their investments.

“As Warren Buffett said, risk comes from not knowing what you are doing, so I urge everyone to get a good education, so you fully understand the risks you are taking before you invest and not when you are losing money because then it’s too late,” he said.