Stock market foundationsModule 5, lesson 25 of 29
The risks of investing in shares
The main risks of owning shares, from one company failing to market-wide falls, illiquidity and borrowed money, and the habits that keep them in check.
In this lesson
- Name and explain the main types of risk in owning shares.
- Show with numbers how diversification limits the damage from one bad company.
- Show with numbers how borrowed money magnifies losses.
- Describe simple habits that keep risk within limits you can live with.
Builds on
- Bull markets, bear markets, corrections and crashesMarket-wide falls and the maths of recovery are the background to every risk in this lesson.
- Bid, ask, spread and liquidityLiquidity risk builds directly on what liquidity is and how it shows in the order book.
On this page
In simple terms
Shares can lose value, sometimes a lot of it, and sometimes for a long time. That is not a flaw in the market; it is the other side of the higher returns shares can offer. The point of understanding risk is not to avoid it entirely, but to take only risks you understand, in amounts you can survive.
The main risks fall into a few groups.
The main risks
Company risk. A single business can lose customers, be overtaken by competitors, take on too much debt, suffer a fraud, or simply be badly run. Its shares can fall sharply and, in the worst case, become worthless. This risk is specific to each company.
Market risk. Sometimes nearly all shares fall together, in a bear market or a crash, because of a recession, a financial crisis or a sudden shock. Owning many different companies does not protect you from this, because they all fall at once.
Liquidity risk. You may not be able to sell when you want, at a fair price. This is a particular danger in small, thinly traded shares, and it gets worse during market panics, when buyers disappear.
Leverage risk. Borrowing to invest, through margin trading facilities or derivatives such as futures and options, magnifies every move. Losses can exceed what you put in, and you still owe the loan and its interest.
Concentration risk. Putting a large share of your money into one company, one sector or one idea means a single mistake can do serious damage.
Inflation risk. Over long periods, money that is not growing loses buying power as prices rise. This is a risk of not investing, and of investing too cautiously, rather than of owning shares.
Behaviour and fraud risk. Panic selling, chasing tips, and falling for scams cause many of the worst losses individual investors suffer. These are risks you control more than any other.
Diversification: spreading company risk
Diversification means spreading money across many companies, ideally in different industries, so that any one failure does limited damage.
Worked example: One basket or many
You have ₹1,00,000 to invest. Compare two approaches when one company runs into serious trouble and its share price falls 80%.
| All in one company that falls 80% | −₹80,000 |
|---|---|
| Split equally across 20 companies; one falls 80% | −₹4,000 |
| Difference made by diversification | ₹76,000 |
In the diversified portfolio, the problem company held only ₹5,000, so an 80% fall costs ₹4,000, or 4% of the portfolio.
Diversification works well against company risk. It does little against market risk: in a broad bear market, a portfolio of 20 companies can still fall 30% or more. That is why time horizon matters too.
Leverage: how borrowed money magnifies losses
Worked example: Buying with a loan
Ravi has ₹50,000 and borrows another ₹50,000 to buy ₹1,00,000 of shares. The shares then fall 20%.
| Value of shares after a 20% fall | ₹80,000 |
|---|---|
| Loan still owed | ₹50,000 |
| Ravi's own money left | ₹30,000 |
| Loss on his own ₹50,000 | 40% |
A 20% fall in the shares became a 40% loss of Ravi's own money, before any interest on the loan. If the shares had fallen 50%, his own money would be gone entirely. Lenders and brokers can also demand more money or sell the shares automatically when prices fall, often at the worst moment.
Leverage magnifies gains in exactly the same way, which is why it is marketed so heavily. SEBI's own study found that most individual traders in futures and options lost money; see Investing compared with trading.
Habits that keep risk manageable
- Keep an emergency fund first. Money you might need within a year or two belongs somewhere stable, not in shares. If you are forced to sell during a fall, a temporary loss becomes permanent.
- Invest for the long term. Shares can fall for years at a time. Money you will not need for five years or more can wait out a bear market far better than money needed next year.
- Diversify. Hold many companies across different industries, or use a diversified fund.
- Avoid borrowed money. If you are learning, do not use leverage or derivatives at all.
- Size each position so one mistake cannot hurt badly. A useful question: if this company went to zero, could I live with the loss?
- Understand what you own. If you cannot explain how a company makes money, you are relying on hope.
- Ignore tips and guarantees. Nobody can guarantee returns from shares. Anyone who does is either mistaken or dishonest.
Why it matters
Most people who are badly hurt by the stock market are not hurt by ordinary ups and downs. They are hurt by concentration, leverage, needing the money at the wrong time, or fraud. Each of these is largely avoidable. Understanding the types of risk lets you decide in advance which ones you will take, and how much.
Limitations
No set of habits removes risk. A diversified, unleveraged, long-term portfolio can still fall sharply and take years to recover, and the past recoveries of broad markets are not a guarantee about the future. The right level of risk also depends on your circumstances: your income, your obligations and how soon you need the money. This lesson is general education, not personal advice.
Common mistakes
- "Large companies are safe." Size reduces some risks but does not remove them.
- "Owning 30 shares in the same sector is diversified." If the sector falls, they may all fall together.
- "I'll use a little leverage to grow faster." Leverage turns ordinary falls into large, sometimes total, losses.
- "I'll invest the money for my fees due next year." Short-term money does not belong in shares.
- "If I don't sell, I haven't lost." The value has fallen whether or not you sell.
Try it yourself
Write down, for any money you are thinking of investing:
- When might you need this money? If the answer is within the next three years, reconsider.
- If the investment fell 30% next month, would you need to sell? Would you sleep?
- How many separate companies or funds would it be spread across?
- Is any of it borrowed?
These four answers will tell you more about your real risk than any share price chart.
Key takeaways
- Owning shares carries several distinct risks. One company can fail, the whole market can fall, you may be unable to sell, and borrowed money can turn a fall into a disaster.
- Diversification across many companies and sectors limits the damage any single company can do, but it does not protect you from a market-wide fall.
- Leverage multiplies losses as well as gains. A 20% fall on a position bought half with borrowed money wipes out 40% of your own money, before interest.
- Invest only money you will not need for several years, keep an emergency fund separately, and never invest borrowed money you could not afford to lose.
Check your understanding
Try the numbers yourself
- Leverage calculatorWhat does borrowing to invest do to my risk?
- Loss recovery calculatorWhat gain do I need to recover from a loss?
- Real return calculatorWhat is my return after inflation?
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Terms used in this lesson
- Diversification
- Spreading money across many investments, so that a problem with any one of them does limited damage.
- Leverage
- Using borrowed money, or products such as futures and options, to take a bigger position than your own money allows, magnifying gains and losses.
- Liquidity
- How easily an asset can be bought or sold quickly, in meaningful amounts, without moving its price much.
- Volatility
- How much and how quickly a price moves up and down. Highly volatile shares swing sharply in both directions.
- Inflation
- The general rise in prices over time, which reduces how much a given amount of money can buy.
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This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.