You get a text from your best college buddy saying to call him ASAP. On the phone, he can barely contain his excitement. His brother-in-law works at a popular high-tech company that's about to announce a revolutionary new product. Your friend is an active day trader — someone who buys and sells stocks online — and guarantees that the company's stock will soar on the news. If you invest $1,000 today, your shares will be worth twice that amount by the end of the week. He's going all in. What do you say?
With financial investments, there is no reward without risk. The riskiest bets, like short-term investments in a volatile stock market, can bring the greatest rewards, but also stunning losses. The truth is that your friend's "sure thing" is anything but, and investors need to understand how different risk factors can impact their financial future.
Even the most conservative investment, such as an FDIC-insured certificate of deposit (CD), carries a degree of risk. If the interest rate on the CD is too low, your investment might be outpaced by inflation [source: Financial Industry Regulatory Authority].
Smart investors try to manage risk by investing in a diverse portfolio of stocks, bonds, CDs and other financial instruments, often through a professionally managed mutual fund. But other investors prefer a more hands-on approach, buying and selling stock in individual companies, either through a broker or an online trading Web site. If you're thinking about investing in a particular company rather than a diversified mutual fund, you need to go with more than your gut instincts. You need to analyze the specific risk factors that come with every investment and every company.
Start by researching some basic questions: What do Wall Street analysts expect from the company's next earnings report? How does the company's historic stock price compare with market indexes like the Dow Jones Industrial Average? Has the company weathered the recession well? Is any member of the top management team under investigation? Are any of its exec selling off lots of their holdings?
We've compiled a list of 10 significant risk factors that can cause an investment to sink or soar. There's no way to remove all of the risk of investing — even your mattress loses to inflation — but by doing your homework, you can identify key trends and invest with greater confidence. Let's start with a look at the big-picture performance of an entire industry or sector.
When evaluating the risk of investing in a particular company, start with the big picture. Every company is unique, but individual success also depends on trends within the business sector as a whole. Let's say you're thinking about investing in an auto company. You might notice newspaper articles reporting a decreased demand for large, heavy trucks, but an increased demand for fuel-efficient vehicles. To lessen your risk, you would want to invest in a car company that designs lightweight or hybrid vehicles.
A business sector can be as broad or specific as you want. You can look for data and analysis of the entire consumer electronics sector or you can home in on mobile computing devices like notebooks, netbooks and tablets. Most business sectors are covered by "trade" publications and Web sites — check out the Yahoo! trade magazine directory — that go into great detail about industry sales figures and trends.
Major newspapers like The Wall Street Journal, The New York Times and the Financial Times also publish in-depth coverage of business trends and industry performance. And don't forget social media. Stock analysts and "experts" of varying qualifications have flocked to sites like Twitter, Facebook and Google+ to share the latest financial reports and industry news [source: Koning Beals].
When evaluating the performance of an entire business sector, pay attention to whether the sector is dominated by one or two major players, or if the market share is spread out more evenly. Now let's talk more about evaluating the competition.
Companies do not exist in a bubble. They are the product of both consumer demand and their competitive environment. The most successful company is the one that grabs the biggest piece of the pie — known as market share — from the competition. But the company with the biggest market share doesn't necessarily make the best investment. Why is that?
The only way to make money with an investment is through growth. When you buy stock in a company, you purchase a set amount of shares at a specific price. The only way to make money from that investment is to sell the stock at a higher price. While there are many factors that influence stock price, market share plays a significant role. So rather than looking for the company with the biggest market share, the savvy investor looks for the company with the greatest potential to increase its market share in the future.
PC operating systems are a great example. Microsoft currently dominates the operating system market with more than 90 percent of the world's computers running on some flavor of Windows [source: Whitney]. But Microsoft's very large piece of the pie has been slowly nibbled away by Apple over the past decade, and the entire PC sector is shrinking as more consumers move to mobile devices. Which company's product offerings have the greatest growth potential? Again, there are many factors to consider, but market share trends should be part of any investment risk management equation.
A quarterly or annual earnings report provides the clearest picture of a company's financial health. By learning how to read and understand the different financial statements in an earnings report, you can decide if an investment is worth the risk. No single financial statement tells the whole story. You need to take all of the numbers into account to get an accurate picture of the company's current health and future prospects. Here are the most important statements:
A balance sheet presents a picture of the total assets and liabilities held by a company at a specific moment in time. Assets include everything a company owns, from factories to trucks to unsold inventory. Liabilities are everything it owes, including loan payments, salaries and rent.
By subtracting liabilities from assets, you arrive at shareholder's equity, or how much investors would receive if the company liquidated its assets and paid off its debts right now. If you divide liabilities by shareholder's equity, you get the debt-to-equity ratio, a measure of how quickly a company is taking on debt compared to attracting investor money [source: Securities and Exchange Commission].
An income statement shows how much a company earned in a given period and the expense of doing business. The bottom line, after all expenses are subtracted from gross revenue, is net profit or net losses. Remember that profits or losses for a single quarter or year aren't a clear indication of the risk of the investment. They are merely factors in a larger financial picture.
The cash flow statement offers more details about how money is actually received and spent at the company. A company might report high earnings, but what if half of those earnings are IOUs for cash that has yet to arrive? This could limit the company's ability to invest in growth or even pay its expenses [source: SEC].
Don't forget the footnotes of any financial report, because they often contain important information about the company's accounting policies and methods. Another particularly helpful section is the five- or ten-year summary provided at the back of many earnings' reports [source: Merrill Lynch]. This helps you compare the information from the current report with past performance to identify trends that affect the risk of the investment.
Before you invest in a company, you need to make an important decision: Are you in for the long haul, or do you want to turn a quick profit and get out? There are big differences between short-term and long-term investment strategies, particularly when you're dealing with the stock market. In both cases, you want to start by charting the historic performance and volatility of the company's stock price.
Visit a Web site like Yahoo! Finance or Google Finance to view the historic performance of your target stock. A helpful tool on these Web sites is the ability to add an entry for the Dow Jones Industrial Average, the S&P 500 and the stock prices of related companies. See if the stock price of your target company outperforms, underperforms or mirrors the broad market indexes and its competition.
As you zoom in from the five- or ten-year view to the yearly or monthly charts, you will notice far greater fluctuations in the stock price. This is called short-term volatility, and that's why short-term investing is such a risky game. It is extremely difficult to predict the short-term movements of any stock, because stock prices can be influenced by countless factors, only a few of them related to the performance of the company itself.
This is why investment experts recommend taking a long-term strategy. As you can see in a five-year view of the market, long-term trends are easier to spot. Even with stock market crashes, recessions and bubbles, the average annualized growth rate of the S&P 500 during the past 50 years is between 6 and 7 percent when adjusted for inflation [source: Moneychimp].
That seems to make long-term investing a guaranteed success. But as every investment advisor will tell you, past performance is not an indicator of future results. Even long-term trends are susceptible to unforeseen risks and shifts. Just ask the folks who planned to retire in 2010, but whose 401(k) accounts were cut in half by the 2008 recession. Trying to predict the long-term performance of a single company is even more difficult, but past performance will give you a better sense of the level of risk you are taking.
There's a reason why CEOs, presidents and chairmen of the board get paid the big bucks. Top-level management is responsible for making the decisions that can result in huge profits or crushing losses. Sure, their decisions are based on data and advice generated by in-house staff and teams of outside consultants, but the buck has to stop somewhere. Before you invest in a company, you should get to know its leadership team and its penchant for making risky decisions.
Experience is a good place to start. Where have the top managers worked before? Did they successfully helm a similar type of business? Have they shown loyalty by sticking with the same firm for a number of years, or have they bounced around from job to job? Google their names and see what the press has to say. Have they been implicated in any civil lawsuits? Have they been charged or convicted of any crimes? A checkered past isn't necessarily a deal breaker, but it raises the risk level for future bad decisions.
Also remember that even charismatic, visionary leaders can have a downside. What happens when they leave? The passing of Steve Jobs in 2011 is one of many factors that have some investment experts predicting an imminent crash for Apple stock [source: Wasik]. And leaders with too much self-confidence can lead to risky decisions. A 2013 study of CEO signatures found that those with the largest signatures — a sign of narcissism — were prone to "overinvestment," spending too much on fast growth, capital expenditures and pet projects, while letting revenues slide [source: Ham et al.].
What have you done for me lately? That's the question every investor needs to ask of a target company. Since past success is no indication of future performance, investors should focus on the next big product or service coming down the research and development pipeline. Will it be smart, strategic and sexy enough to increase sales and market share, or will the company's lack of vision give an edge to the competition? That's the risk of R&D.
Witness the sad tale of BlackBerry and its parent company Research In Motion (RIM). The iconic BlackBerry device, with its nifty keyboard and push messaging system, ruled the U.S. smartphone market in the early 2000s. BlackBerry held more than 50 percent of smartphone market share as late as the first quarter of 2009 [source: Elmer-DeWitt].
But even as sales of the sleek Apple iPhone began to gather steam, BlackBerry failed to develop a robust new operating system and interface to compete with the rest of the touchscreen pack. Its entrance into the touchscreen market, the 2008 BlackBerry Storm, was panned by critics for sluggishness and bugs, and virtually ignored by consumers [source: Cha]. As of late 2012, BlackBerry's U.S. market share was down to a depressing 1.6 percent [source: Austen].
As an investor, look for a company with a proven track record for strategic innovation, but remember that one or two breakthrough products isn't enough to sustain the company forever. You can lower the investment risk by betting on companies with a deep inventory of fresh ideas.
We hear a lot of talk of businesses "going global," and assume that means the company is selling its product or service worldwide. But even if an American company exclusively sells its services in the U.S., it still may depend heavily on labor and raw materials from other, often less stable regions of the world.
"American" products are made in Mexico, China and India, and the materials to make those products — oil, rare metals, lumber — are extracted from oilfields, mines and rainforests in countries that change leaders through coups and uprisings more often than democratic elections. Find out where your target company makes its products and how dependent it is on resources from politically unstable regions [source: FINRA].
We should note that not all investors are risk-averse. Some investors — investment professionals, more likely — specialize in "emerging markets," countries whose economies are expanding rapidly, but lack the financial infrastructure and regulations of more established markets. The greater risk of such investments can result in larger and faster returns than a more conservative investment, but the potential for loss is equally high.
The only thing Wall Street likes less than a poor earnings report is an investigation by the U.S. Department of Justice (DOJ). If you want to avoid a risky investment, steer clear of companies that are under active investigation by the DOJ's Antitrust Division or the Enforcement Division of the Securities and Exchange Commission (SEC). If a company is convicted of deceptive accounting practices, fraudulent reporting of earnings or unfairly squashing competition, that's going to scare away investors and cause the stock price to sink.
Then again, even a major legal judgment doesn't necessarily signal the end. Look at Microsoft, which was convicted in 1999 of violating antitrust laws with its Windows operating system, but paid its debt, restructured its business, and survived on the strength of its sales and continued market share dominance. Some investors actually look to buy stock in an otherwise strong company that's been hit with a legal setback. The trick is to identify the point at which the stock price bottoms out before beginning its rebound [source: Austria Farmer].
Some legal troubles are too big to escape. When government regulators and fraud investigators began swarming the headquarters of energy giant Enron in 2001, it became very clear, very fast, that the former Wall Street darling was never going to bounce back. Investors dumped their Enron stock as fast as they could, leaving latecomers with once "golden" stock certificates that weren't worth the paper they were printed on [source: Kadlec].
Shares in BP traded on the New York Stock Exchange at $59.88 on April 23, 2010, just days after an explosion on the Deepwater Horizon offshore oil rig claimed 11 lives and triggered what would become the largest oil spill in the history of the industry [sources: Google Finance USA Today]. Two months later, BP's stock bottomed out at $27.02, less than half its pre-spill price.
The BP oil spill is a stark reminder that some of the world's most profitable companies are engaged in work that is risky by nature and potentially dangerous to workers, the public and the environment. Oil is a critical commodity, but its extraction, transportation and refinement carries the risk of fire, spills and explosions. In the United States, there's a lot of excitement over natural gas extraction, but some investors are wary of the potential for drinking water contamination following an industrial accident.
When analyzing your investment options, consider the risk of a major fire, natural disaster or environmental emergency. Examine the company's commitment to worker safety, facility security and environmental stewardship, and make sure that their actions match their words.
Remember too, that strong companies can also bounce back from disasters that would wipe out weaker competition. By February 2013, BP stock was trading at $42. Investors who doubled down on BP in the months after the disaster would have made a tidy profit.
In the United States, Congress writes laws intended to protect the environment, consumers and investors. It is the task of regulatory agencies like the Environmental Protection Agency, Federal Trade Commission and the Securities and Exchange Commission to enforce those laws, which can include filing lawsuits against companies that violate federal regulations. Individual states have their own regulatory agencies, which enforce their own standards according to state law. A savvy investor scans the business news to keep tabs on proposed regulations that could affect entire industries.
When there's a shift of political power at the state or federal level, the priorities of regulatory agencies can also shift. The energy sector is a great example. Eric Cantor, a Republican Congressman from Virginia, believes that overzealous environmental regulations proposed by President Barack Obama threaten the profitability of the coal, natural gas and auto industries [source: Cantor]. On the flip side, some economists see environmental regulation of the energy industry as a force for innovation, spurring investment in alternative energy sources [source: Hilzenrath].
Regardless of your political or economic opinion of regulations, you need to analyze the potential risks associated with increased or decreased regulation to the profitability of your target company and make the smartest bet possible.
For lots more investment tips and financial information, check out the related HowStuffWorks articles on the next page.
HowStuffWorks finds out if and when leaving more money to one child than the others is a good idea and how to cut down on the hurt feelings that might result.
Author's Note: 10 Significant Risk Factors When Investing In a Company
If the Great Recession has taught us anything, it's that there is no such thing as a safe bet. I think about my parents, baby boomers who dutifully squirreled away money into their 401(k) plans and Roth IRAs, confident that the stock market would continue its upward climb for eternity, or at least until they were safely settled into retirement bliss. But all of the talk of the market's average long-term returns didn't mean squat as my parents saw their hard-earned next egg lose half its value from 2008 to 2010 and their retirement dreams began to look more and more like a fantasy. The lesson, I suppose, is that we all need to be aware of the significant financial risks we take with any investment. Yes, there are tremendous benefits to 401(k) plans and managed mutual funds, but none of us should act on blind faith that stock markets always grow, home prices always increase, or natural disasters never happen around here. Better to be educated, prepared and in control. That won't take away the risk, but at least we'll have a plan B.
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