Types of Risk in the Stock Market

5 mins read
by Angel One
The stock market involves systematic and unsystematic risks. Understanding inflation, interest rate, liquidity, business, and credit risks helps investors manage losses through different methods.

Investing in the stock market comes with risks, but understanding them can help you make smarter decisions. Some risks are unavoidable, while others can be reduced with good strategies, in this article, you’ll learn about different types of risk in the stock market, how they impact your investments, and ways to manage them.

Systematic Risk (Market Risk)

What is Market Risk?

Market risk, also known as systematic risk, refers to the possibility that you may experience losses due to factors affecting the overall performance of financial markets and the general economy. This type of risk cannot be eliminated through diversification because it impacts the entire market.

Causes of Market Risk

  • Economic downturns
  • Interest rate changes
  • Inflation
  • Geopolitical events
  • Natural disasters

Examples:

  • The 2020 COVID-19 pandemic led to a major stock market crash in India, affecting Sensex and Nifty.
  • The 2022 Adani Group stock crash following allegations of fraud impacted the overall Indian stock market sentiment.

Types of Systematic Risk

1. Inflation Risk

Inflation risk, also called purchasing power risk, refers to the chance that the cash flows from your investment will lose value in the future due to inflation. As prices rise, the value of your money decreases, reducing the real return on your investments.

Examples:

  • The sharp rise in food and fuel prices in India during 2022-23 reduced the purchasing power of consumers and affected investment returns.
  • The RBI’s continuous rate hikes in response to high inflation in 2023 impacted stock market growth.

2. Interest Rate Risk

Interest rate changes impact stocks, bonds, and other investments. When interest rates rise, borrowing becomes expensive, which can slow business growth and affect stock prices.

Examples:

  • The RBI’s interest rate hikes in 2022-23 led to a decline in real estate and banking sector stocks.
  • The rising repo rate in 2023 made borrowing costlier, impacting auto and housing finance companies.

3. Liquidity Risk

Liquidity risk arises when an investment cannot be bought or sold quickly. If an asset is not easily tradable, you might have to sell it at a lower price, causing losses.

Examples:

  • The IL&FS crisis in 2018 led to a liquidity crunch in the Indian financial markets.
  • In 2023, several Indian start-ups struggled with liquidity due to reduced venture capital funding.

4. Political and Regulatory Risk

Government policies, trade restrictions, and sudden regulatory changes can influence market movements. You may experience losses if a country imposes new tax laws or changes financial regulations.

Examples:

  • The Indian government’s 2022 decision to impose windfall taxes on oil companies affected stock prices in the sector.
  • The sudden ban on high-value currency notes (demonetisation) in 2016 led to market uncertainty.

5. Currency Risk (Exchange Rate Risk)

Currency risk refers to the potential loss caused by fluctuating foreign exchange rates. If you invest in foreign stocks or bonds, you may experience gains or losses due to changes in currency values.

Examples:

  • The depreciation of the Indian Rupee against the US Dollar in 2022 increased the cost of imports and affected companies reliant on foreign supplies.
  • The 2013 Rupee crisis, when the currency fell sharply due to foreign investor outflows, impacted stock markets.

Unsystematic Risk (Specific Risk)

Unsystematic risk, also called specific risk, is linked to a particular company or industry. Unlike market risk, you can reduce it by diversifying your investments.

1. Business Risk

Business risk refers to the possibility that a company you invest in may face losses or even shut down due to poor management, declining demand, or financial instability.

Examples:

  • The 2023 Byju’s financial crisis, where the edtech giant struggled with mounting losses and investor exits.
  • The fall of Jet Airways in 2019 due to mismanagement and rising operational costs.

2. Financial Risk

This risk is related to a company’s ability to meet its debt obligations. High debt levels can make companies vulnerable to economic downturns.

Examples:

  • The DHFL collapse in 2019 due to excessive debt and financial mismanagement.
  • The Yes Bank crisis in 2020 led to the bank’s stock plunging and required government intervention.

3. Industry-Specific Risk

Some industries are more volatile than others. For example, technology and airline companies face greater risks due to innovation and fuel price fluctuations.

Examples:

  • The decline in Indian IT stocks in 2023 due to concerns about global recession and reduced outsourcing demand.
  • The rise in fuel prices in 2022 heavily impacted Indian airline companies like IndiGo and SpiceJet.

4. Volatility Risk

Volatility risk arises as stock prices fluctuate over time. Some stocks have high price swings, making them riskier for short-term investors.

Examples:

  • The extreme fluctuations in Adani Group stocks in 2023 after a short-seller report alleged financial irregularities.
  • The price swings in Paytm’s stock after its 2021 IPO due to investor uncertainty.

5. Credit Risk

This refers to the possibility that a company may fail to repay its debt, impacting you if you hold bonds or lend money to the firm.

Examples:

  • The Vodafone Idea financial crisis due to its high debt burden and AGR dues.
  • The default of Reliance Communications in 2019, which led to investor losses.

How to Manage Risks in the Stock Market?

1. Diversification

Investing in a mix of stocks, bonds, and other assets helps spread risk. Even if one investment performs poorly, others may perform well, balancing your overall returns.

2. Hedging

Investors use strategies like options and futures contracts to protect themselves against market downturns.

3. Asset Allocation

Dividing investments across different asset classes based on financial goals and risk tolerance can help manage risk.

4. Research and Analysis

Before investing, research company fundamentals, industry trends, and economic indicators to make informed decisions.

Conclusion

Investing in the stock market involves risk, but understanding these risks can help you make better decisions. Systematic risks affect the entire market, while unsystematic risks impact specific companies or sectors. By diversifying your investments, using risk management strategies, and staying informed, you can minimise potential losses and maximise returns.

FAQs

Can diversification eliminate all risks?

No, diversification reduces unsystematic risk, but systematic risk always remains. You can only manage it by using hedging and asset allocation strategies.

How does inflation affect investments?

Inflation reduces the purchasing power of your money, making your future returns worth less. This means your real investment growth is lower over time.

How can you manage liquidity risk?

Investing in highly traded stocks and maintaining a cash reserve can help you avoid liquidity issues. Always check trading volumes before investing in less popular stocks.

Should you worry about currency risk if you invest only in Indian stocks?

Usually, currency risk affects those who invest in foreign stocks or bonds. However, exchange rate fluctuations may still impact companies with international operations.