Investing Risks In The Stock Market

Investing carries various risks based on the returns you aim to achieve. For low risk and low returns, consider a term deposit. For high risk and the potential for quick high returns, look into cryptocurrency.

This might lead you to believe that risk is tied to volatility—term deposits are stable, while crypto markets fluctuate wildly.

Property prices appear stable, but you only know their value twice: when you buy and when you sell. Also, buying property often involves taking on significant leverage, which adds its own risk.

The stock market, in my view, offers a balanced option. Intelligent investing can yield high returns with relatively low risk. However, investing risks exist across all asset classes.

Recent events underscore this fragility. At the beginning of August 2024, US unemployment data disappointed the markets. There is also raising concerns about tech companies’ AI investments showing too little compared to the input.

Alongside these macroeconomic issues, the Bank of Japan’s interest rate hike triggered the largest stock market decline in four years on August 5, 2024. The Nikkei saw their market drop over 12% on 05 August with the global markets not faring better.

This serves as a crucial reminder: investing involves risks, and the public markets can be unpredictable. Always keep this in mind when navigating the investment landscape.

What Happened in August 2024?

Recent events in August serve as a stark reminder of the inherent investing risks. While it might sound repetitive, a few fundamental principles can help us avoid costly mistakes. Naivety in investing can lead to significant losses.

First and foremost, we shouldn’t take everything the media or politicians say at face value. We need to conduct our own research and form independent views.

Macroeconomic conditions have been troubling for the past year. Despite data suggesting we’re not technically in a recession, I would argue otherwise. A recession is defined by negative GDP growth for two consecutive quarters, yet recent figures show positive growth largely due to population increases and government deficit spending, which exacerbates inflation.

Quarters	GDP growth
March 23 – June 23	0.4%
June 23 – September 23	0.2%
September 23 – December 23	0.3%
December 23 – March 24	0.1%

Australia isn’t alone in facing economic challenges. Global markets, including the United States, are also struggling with a weaker job market. Economic weaknesses suggest reduced spending and declining business profits.

Large tech companies like Intel, Microsoft, Intuit and Telstra in Australia have been laying off employees as they feel the financial squeeze. More recently, tech firms investing heavily in AI face scrutiny for excessive capital spending with little to show for it.

This raises questions for investors about when these companies will see returns on their AI investments, which may not materialize anytime soon. As a result companies like Nvidia, Amazon, Apple have seen their share prices fall significantly over the last few weeks.

In light of these challenges, it’s crucial to remain vigilant and aware of the investing risks that can affect our financial decisions.

Investing Risk When Using Debt

Debt is a double-edged sword, capable of amplifying gains but also burying you in losses. The late Charlie Munger famously said, “There are only three ways a smart person can go broke: liquor, ladies, and leverage.”

The first two were added for humor, but leverage is the real culprit that heightens investing risks. Banks, operating on borrowed money, exemplify how fragile leverage can be. The 2008 financial crisis is a stark reminder of how the misuse of debt can devastate the global economy.

In August 2024, we witnessed another example of leverage’s dangers. Japan, after years in a negative interest rate environment, increased rates to 0.25%. This shift might seem minor compared to Australia’s rates, but it had significant repercussions for foreign investors.

These investors borrowed yen at low rates to invest in U.S. assets, primarily stocks. When Japan raised rates, loan repayments became more expensive, and a U.S. stock market correction triggered margin calls, forcing them to sell stocks.

This situation, known as a carry trade, led to a rush to repurchase yen, strengthening its value. Debt forces investors to sell even when they don’t want to. While such events cause market panic and sell-offs, they also present opportunities to buy stocks at lower prices if you can navigate the volatility.

Understanding and managing investing risks, especially those associated with leverage, is crucial for long-term financial health. Never take on more than you can lose, the last place you want to be is starting from nothing.

Mitigating Investing Risks

Eliminating risk entirely is impossible if you want returns that outpace inflation. No one ever got rich through savings alone.

Term deposits and high-yield savings accounts rarely offer interest rates that surpass infaltion. While your interest yield might rise during inflationary periods, your purchasing power only barely keeps pace, if you’re lucky.

To grow your money and outpace inflation, you need to explore investments with higher returns. Historically, stocks have been the best-performing asset over the past century, delivering a nominal 10% return.

However, high returns come with investing risks. While you can’t eliminate these risks, you can mitigate your exposure.

First, diversification is crucial. It might reduce your overall returns, but it also protects you from large losses due to over concentration. Diversifying reduces risks from single investments but doesn’t eliminate systemic risks that affect the broader economy.

History teaches us to respect leverage as a tool. Abusing debt levels can lead to disastrous outcomes. You never want to be in a position where you have to start from scratch. Why risk what you have and need for something you don’t have and don’t need? The goal is to stay rich, not to play heads I win, tails I lose.

Valuation also plays a key role in long-term investment success. The price you pay for an asset ultimately determines your returns. Overpaying leaves less room for error if things go wrong.

The risk-reward potential should be favorable. I call this risk asymmetry: if something goes wrong, your potential loss is small, but if it goes right, your potential for outsized returns is significant.

Key Takeaways

• Recent events in August highlight the inherent investing risks and emphasize the importance of fundamental principles to avoid costly mistakes. It is important to always conduct your own research and form independent views.
• Debt amplifies both gains and losses, highlighting significant investing risks. Leverage, as Charlie Munger noted, is a key risk factor. Recent events in Japan exemplify debt’s potential to trigger market turmoil.
• To outpace inflation, explore higher-return investments like stocks, but be aware of investing risks. Diversify, respect leverage, and focus on valuation to mitigate potential losses and achieve favorable returns.

Incognito Wealth – Investing Tools

Need help with investing in the stock market or personal finance? Visit my Etsy store for digital excel templates. Simplifying finance so that everybody can reach financial independence

Incognito Wealth - Financial Independence One Investment at a Time