The Real Risks In Investing

Does the stock market feel like a particularly risky place to be in right now? I can’t know for sure, but my logical guess for the answer that most investors will give is “Yes!” After all, the Straits Times Index (SGX: ^STI) is sitting on a 27% decline from a 52-week high at its current level of 2,586 points.

Blue chip stocks – the 30 companies that make up the Straits Times Index – such as Noble Group Limited (SGX: N21), Semcorp Marine Ltd (SGX: S51), and Genting Singapore PLC (SGX: G13), have fared way worse, falling by 77%, 53%, and 38%, respectively, from their 52-week highs.

When stock prices fall sharply, it’s easy to imagine investors looking at the stock market with distrust and harbouring thoughts about how risky it is. As such, I think it’s a good time to be discussing the real risks involved with stock market investing.

In my opinion – and I’m not alone – investing risk comes primarily from the underlying business fundamentals of the stock.

Peter Lynch, the legendary manager of the Fidelity Magellan Fund, wrote in his book Beating the Street that “often, there is no correlation between the success of a company’s operations and the success of its stock over a few months or even a few years. In the long term, there is a 100 percent correlation between the success of the company and the success of its stock.” Put another way, if a company has a lousy and risky business, it will likely have a lousy stock too.

So, here are a few questions which may be helpful when trying to assess business risks:

1. Does the business have a strong balance sheet?

In good times, the use of leverage can magnify returns. But, debt weakens a company’s balance sheet and in bad times, it can act as an albatross around the firm’s neck and cause the firm to be beholden to its creditors; worst-case scenarios may even result in bankruptcy.

2. Has the business been able to consistently produce cash flow and profits historically?

The past is no guarantee for the future. But, a company with a solid history of profit and cash flow generation can lend investors some confidence that it may continue doing so in the years ahead.

3. Does the business have a strong competitive advantage against its peers?

A competitive advantage gives a firm pricing power and thus the ability to protect its profits and cash flows. In the absence of a competitive advantage, a business’s profitability may be chipped away over time (sometimes swiftly) by the relentless forces of capitalistic competition.

My list above is far from exhaustive. But it should still provide a useful head-start in thinking about investing risks. Falling stock prices are not fun to stomach, but it pays to keep a focus on real investing risks at all times as it can help give you the right perspective when dealing with declines in the prices of your holdings.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any companies mentioned.