Because the price of a stock is only what someone is willing to pay at any given time, the price can and does fluctuate. Understanding some of the risks involved is key to making smart financial decisions. A good rule is to never keep more in a single stock than you would be willing to lose.
As can be seen from this list, even when companies seem invincible there are alarge number of events that could cause the stock to decline rapidly overnight. When one doesn’t have much to lose, it makes sense to concentrate. When one starts to amass enough to protect, diversification is wise.
Here are some of the risks associated with stocks:
1. The stock will decline rapidly in price. Stocks commonly fluctuate by 10-20% or more over a period of weeks or months. Some days individual stocks may move by 10% or more. The risk from price fluctuations can be smoothed out by diversifying into several stocks or buying mutual funds, which buy large numbers of stocks.
2. Fraud by companies or officers. Perhaps one of the events that cause the most rapid drop in stock price is fraud or even simply allegations of fraud. One rule is to look for unexpected departures by the Chief Financial Officer, or CFO. Because that individual is intimately tied to the finances, chances are that if a company is cooking the books, he’s either involved or sure to find out. Either way he may decide to take another job or “spend time with his family.” Once again, diversification is the key.
3. Government regulations may affect future earnings. If the government passes a new regulation that may cut into a company’s profits, causing the stock price to decline. When investing in foreign stocks this can be especially important since some governments may simply seize the assets of a company. Before investing internationally it is wise to understand the politic of the country, and also spread assets out into several different countries to reduce risk.
4. The company may go bankrupt. When a company goes bankrupt the stock will often be deemed worthless. Even if the company comes out of bankruptcy court, new shares of stock may be issued, making old shares worthless.
5. The company stock may not go anywhere. While it is better that a company’s stock stays at the same price than decline in price, a stock that does not increase in price represents a loss both sue to inflation and the missed opportunity (because the money could have been invested elsewhere). Once again, diversification helps mitigate this risk (see a pattern here?).
6. A company may not do as well as competitors. Back when the removable storage devices came out, it looked like IOmega was going to make a lot of money with their external disk drive. Unfortunately, competitors sprang up from the woodwork and IOmega didn’t do well at capturing the market. Even when a company has a revolutionary idea, other companies may be better at marketing/production/ or other factors related to execution.
7. The company may suffer a large loss from a lawsuit. Any company that is successful becomes a target for lawsuits. Because juries tend to take into account the size of a company when setting damages – even though they are usually told not to – a large company could be wiped out by a lawsuit.
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