Life is risky, for we don’t know what will happen in the next moment. Based on this understanding (the unpredictability), we can conclude that even the stock market is risky. How do you manage life’s risk? We do so by building an emergency corpus and taking health and life insurance. Similarly, you need to have a risk management process to reduce the market’s uncertainty. Once you have done that, you can expect higher returns in the stock market. Today, we will understand the risk and reward equation of the stock market.
Risk and Reward equation
Before you invest in the share market, you must understand the risk and reward equation. The equation is simple – the higher the risk, the higher the possibility of returns. The key word in the definition is ‘possibility’. Higher risk does not guarantee higher returns. It only increases the chances of higher returns. Don’t take risks by factoring only the returns. You must take risks as per your risk profile.
Risks associated with the stock market
Below are the risks associated with the stock market:
- Market risk: It is the underlying risk with the securities market due to the overall performance of the market and economy as a whole. It is not specific to a company but more to do with macroeconomics. For example, a war is never good for the market.
- Unsystematic risk: This is the risk associated with the individual industry or company. Unsystematic risk can occur if there is a new competitor for a company, the management is unable to scale the business, issues with a business model, etc. With a risk management process in place, you can reduce the impact of unsystematic risk on your portfolio.
- Inflation risk: Inflation risk is not specific to stock investment, but it is associated with every investment. If you are a short-term investor and have not picked the right stocks, your portfolio may face inflation risk. It is the possibility that the purchasing power of your investment will decline due to inflation. To sum up, if your investment is unable to deliver 6%, your portfolio is under inflation risk.
- Liquidity risk: Liquidity is how quickly you can withdraw your investment to your account. In general, equity investment is liquidity. However, if you have invested in micro or small-cap companies, you may not find a buyer. Hence, equity investments carry some liquidity risk.
Rewards associated with the stock market
The risk discussed above may worry you. However, every coin has two sides to it. If you are looking to invest in the share market, below are some reasons why you must go ahead without a second thought:
- Higher returns: Among all asset classes, equity investment has the potential to deliver the highest returns to investors. If you look at historical data, you can expect an average of 12% returns if you stay invested for the long term.
- Diversification: One way to reduce your risk is to stay invested for a long time. The other thing you can do is diversify your portfolio. The stock market gives you the option to create a diversified portfolio. You can invest in companies from different sectors, market caps, etc.
- Dividend benefits: With stock investment, you not only benefit from stock price appreciation but also receive dividends from some stocks. A dividend is a reward the company gives investors for staying invested in them. Investors looking for passive income can prefer creating a portfolio with dividend-paying stock.
- Flexibility to invest small amounts: To buy gold or invest in real estate, you require a large corpus. However, when it comes to equity investment, you can start with any amount. You can do SIP in stocks and build your corpus over time. Also, it is not mandatory to invest every month – you can also do lumpsum if there is an investing opportunity.
- Investing is super easy: Among all asset classes, buying and selling stocks is the easiest process. You only need to open a DEMAT account, and with a click of a few buttons, you can buy and sell stocks.
If you look at the risks and potential returns, the returns outweigh the risks. Therefore, every investor must consider investing in the stock market. For you, if the risk outweighs the reward, it means you lack the understanding and the required knowledge. Such investors can use technology to invest in the stock market. Check Jarvis – an AI-driven app that makes investment super easy.