Risk is the quantifiable likelihood of loss or less-than-expected return. There is always some degree present in every investment you purchase. Smart investing includes risk management. For each stock, bond, mutual fund or other investment you purchase based on your profiling, there are three distinct risks you must guard against; they are business risk, valuation risk, and force of sale risk.
1. Business Risk
Business risk is, perhaps, the most familiar and easily understood. It is the potential for loss of value through competition, mismanagement, and financial insolvency. There are a number of industries that are predisposed to higher levels of business risk. The biggest defense against business risk is the presence of franchise value. Companies that possess franchise value are able to raise prices to adjust for increased labor, taxes or material costs. The stocks and bonds of commodity-type businesses do not have this luxury and normally decline significantly when the economic environment turns south.
2. Valuation Risk
The danger of investing in companies that appear overvalued is that there is normally little room for error. The business may indeed be wonderful, but if it experiences a significant sales decline in one quarter or does not open new locations as rapidly as it originally projected, the stock will decline significantly. So as an investor you should never ask about whether the company is a good investment option, but inquire about the current price as a good option to invest in the company.
3. Force of Sale Risk
You’ve done everything right and found an excellent company that is selling far below what it is really worth, buying a good number of shares. In this situation this is not advisable for you to be certain about when your stock will appreciate. Do not impose a time limit because in this condition you opened yourself upto tremendous amount of risk. Because at time of need your judgment can be incorrect and turn your potential profits into losses which were missed by you due to time constraints. It is just like missing the right bus when you are in hurry.