Top 10 Universal Risks Every Stock Faces

There are many sector-specific and even company-specific risks in investing. In this article, however, we look at some universal risks that almost every stock faces, regardless of its business.

Impact of Commodity Price Fluctuations on Stocks

Commodity price risk is simply the risk of a swing in commodity prices affecting the business. Companies that sell commodities benefit when prices go up, but suffer when they drop. Companies that use commodities as inputs see the opposite effect. However, even companies that have nothing to do with commodities, face commodities risk.

As commodity prices climb, consumers tend to rein in spending, and this affects the whole economy, including the service economy.

Media Influence and Headline Risks on Stock Performance

Headline risk is the risk that stories in the media will hurt a company’s business. With the endless torrent of news washing over the world, no company is safe from headline risk. For example, news of the Fukushima nuclear crisis in 2011 punished stocks with any related business, from uranium miners to U.S. utilities with nuclear power in their grid.

One bit of bad news can lead to a market backlash against a specific company or an entire sector, often both. Larger-scale bad news—such as the debt crisis in some eurozone nations in 2010 and 2011—can punish entire economies, let alone stocks, and have a palpable effect on the global economy.

How Analyst Ratings Affect Stock Volatility

Rating risk occurs whenever a business is given a number to either achieve or maintain. Every business has a very important number as far as its credit rating goes. The credit rating directly affects the price a business will pay for financing. However, publicly traded companies have another number that matters as much as, if not more than, the credit rating. That number is the analyst’s rating.

Any changes to the analysts rating on a stock seem to have an outsized psychological impact on the market. These shifts in ratings, whether negative or positive, often cause swings far larger than is justified by the events that led the analysts to adjust their ratings.

The Threat of Obsolescence in Modern Business

Obsolescence risk is the risk that a company’s business is going the way of the dinosaur. Very few businesses live to be 100, and none of those reach that ripe age by keeping to the same business processes they started with. The biggest obsolescence risk is that someone may find a way to make a similar product at a cheaper price.

With global competition becoming increasingly technology savvy and the knowledge gap shrinking, obsolescence risk will likely increase over time.

Uncovering Financial Fraud: Understanding Detection Risks

Detection risk is the risk that the auditor, compliance program, regulator, or other authority will fail to find the bodies buried in the backyard until it is too late. Whether it’s the company’s management skimming money out of the company, improperly stated earnings, or any other type of financial shenanigans, the market reckoning will come when the news surfaces.

With detection risk, the damage to the company’s reputation may be difficult to repair, and it’s even possible that the company will never recover if the financial fraud was widespread. Numerous examples include Enron, Bre-X Minerals, ZZZZ Best, Crazy Eddie’s, and the list goes on.

Navigating Legislative Changes: Their Impact on Investments

Legislative risk refers to the tentative relationship between government and business. Specifically, it’s the risk that government actions will constrain a corporation or industry, thereby adversely affecting an investor’s holdings in that company or industry. The actual risk can be realized in a number of ways—an antitrust suit, new regulations or standards, specific taxes and so on. The legislative risk varies in degree according to industry, but every industry has some.

In theory, the government acts as a cartilage to keep the interests of businesses and the public from grinding on each other. The government steps in when business is endangering the public and seems unwilling to regulate itself. In practice, the government tends to over-legislate. Legislation increases the public image of the importance of the government, as well as providing individual congressmen with publicity. These powerful incentives lead to a lot more legislative risk than is truly necessary.

Inflation and Interest Rate Challenges in Investing

These two risks can operate separately or in tandem. Interest rate risk, in this context, simply refers to the problems that a rising interest rate causes for businesses that need financing. As their costs go up due to interest rates, it’s harder for them to stay in business. If this climb in rates is occurring in a time of inflation, and rising rates are a common way to fight inflation, then a company could potentially see its financing costs climb as the value of the dollars it’s bringing in decreases.

Although this double trap is less of an issue for companies that can pass higher costs forward, inflation also has a dampening effect on the consumer. A rise in interest rates and inflation combined with a weak consumer can lead to a weaker economy, and in some cases, stagflation.

Understanding Model Risk in Financial Planning

Model risk is the risk that the assumptions underlying economic and business models, within the economy, are wrong. When models get out of whack, the businesses that depend on those models being right get hurt. This starts a domino effect where those companies struggle or fail, and, in turn, hurt the companies depending on them and so on.

The mortgage crisis of 2008-2009 was a perfect example of what happens when models, in this case a risk exposure model, are not giving a true representation of what they are supposed to be measuring.

The Bottom Line

There is no such thing as a risk-free stock or business. Although every stock faces these universal risks and additional risks specific to its business, the rewards of investing can still far outweigh them. As an investor, the best thing you can do is to know the risks before you buy in, and perhaps keep a bottle of whiskey and a stress ball nearby during periods of market turmoil.

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