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Understanding the risk of investing in shares

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We’ve all heard that there’s no such thing as a free lunch – and this is as true of investing as anything else. Over time, shares have outperformed other asset classes – like government bonds, property and bank deposits – but this comes at a cost.

 

That cost is that investing in shares is riskier than other asset classes. The old adage “high risk, high return” means that an investor who takes on the higher risk of investing in shares expects a higher return for doing so.

 

These are some of the risks of investing in shares:

 

  • Share prices can – and do – go down as well as up. Investors can reduce their risk by doing their homework and always knowing exactly what they’re investing in. That includes evaluating “tips from friends”.
  • Some shares can be illiquid. This means that they can be difficult to trade, often because there is a controlling shareholder who owns a large percentage of the company and is not selling those shares on the market. This means that a share can be difficult to sell. To avoid this, invest in more liquid shares.
  • Companies do not have to pay dividends. This is not necessarily a bad sign if the company is keeping that money to invest in its future growth, but is a risk for shareholders who bought that share for the dividend income.
  • If a company goes bankrupt, shareholders may lose the entire value of their investment. Ordinary shareholders only receive what’s left over once creditors and preference shareholders have been paid their due.
  • Companies can disappoint the market by reporting lower than- expected earnings. This can mean the share price either falls or lags behind the growth of its peers.
  • Share prices factor in the market’s view of management’s competence and integrity. Scandals, such as the revelation of fraud or poor corporate governance, can hurt the share price.

 

But you shouldn’t be frightened off investing in shares. Most listed companies are well-run businesses and their share prices should increase over time.

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