Must-know: 3 key risks in stock market investing

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Sep. 23 2014, Updated 5:01 p.m. ET

Risks to investing in the stock market

The stock markets have a lot to offer. Many avoid investing in stocks, however, because they are afraid of the many associated risks. News about the occasional market recession or slump doesn’t help matters. The confidence of potential investors is eroded, and consequently, they’re excluded from this market of opportunities.

If you’re a potential investor, it’s possible to rid yourself of this fear and make good returns from stocks. The secret is to understand the market and be fully aware of the risks. Be aware of your appetite for risk and invest accordingly. Generally, you can evaluate a potential investment by analyzing three key risks.

Market risk

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An investor may experience losses due to factors affecting the overall performance of financial markets. Stock market bubbles and crashes are good examples of heightened market risk. You can’t eliminate market risk, also called systematic risk, through diversification. You can, however, hedge against market risk.

Even though systematic risk affects the entire stock market, the extent to which the market feels the impact can be minimized. Dividend exchange-traded funds (or ETFs), such as the iShares Select Dividend (DVY) or the Vanguard High Dividend Yield ETF (VYM), can be valuable in this regard.

Inflation risk

Inflation risk, also called purchasing power risk, is the chance that the cash flowing from an investment today won’t be worth as much in the future. Changes in purchasing power due to inflation may cause inflation risk. Some ETFs, including the iShares Barclays Treasury Inflation Protected Securities Fund (TIP), invest in U.S. Treasury inflation-protected securities to minimize inflation risk.

Liquidity risk

Liquidity risk arises when an investment can’t be bought or sold quickly enough to prevent or minimize a loss. You can minimize this risk to a good extent by diversifying. A good option is index investing where risk is diversified over the various stocks held in a portfolio tracking a particular index. ETFs such as the SPDR S&P 500 ETF (SPY) and the Vanguard Total Stock Market ETF (VTI) offer this benefit. They invest heavily in stable large-cap U.S. companies like Apple (AAPL) and ExxonMobil (XOM), and so have minimal liquidity risk associated with them.

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