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What Is Equity Risk?

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  • Written By: A. Leverkuhn
  • Edited By: Andrew Jones
  • Last Modified Date: 18 October 2014
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Equity risk, at its most basic and fundamental level, is the financial risk involved in holding equity in a particular investment. Although investors can build equity in various ways, including paying into real estate deals and building equity in properties, equity risk as a general term most frequently refers to equity in companies through the purchase of common or preferred stock. Investors and traders consider equity risk in order to minimize potential losses in their stock portfolios.

One basic way to limit equity risk is with diversification of stocks. Many professionals encourage investors to hold several stocks in order to provide diversification. The idea is that, if one stock experiences a sudden and significant decline, it will affect the portfolio less if additional stocks or equities are involved. Recently, some experts have been coming out with a more extreme call for diversification, urging the average investor to own at least 30 or more stocks.

Another way to avoid equity risk is in more specific diversification of the types of equities that the investor owns. For example, holding stock in various “sectors” like energy, technology, retail, or agriculture, helps with lowering equity risk. So does buying into a basket of global stocks, rather than keeping all stock investments rooted in the same national economy. All of these methods help investors to balance out their stock purchases and lower the risk that their total values will experience sudden price drops.

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Investors can also use various types of modern funds to help with equity risks. Mutual funds and exchange traded funds are some specific kinds of financial products that can help traders get into more stocks quickly and easily. Many of these funds are a more appealing substitute for all of the tedious single purchases that would go into broader diversification of a stock portfolio.

Beyond all of these beginning techniques for diversification, there are the strategies used by many financial institutions and professional traders. Some of these are often referred to as “hedging” a portfolio. Some of them deal with buying specific “long” or “short” positions that actually gain from inverse price changes, so that no matter what happens, the trader experiences both a gain and a loss. Other strategies include buying more derivative products, like options or futures contracts for underlying equities.

There is a lot for beginning investors to know about how equity risk works. Many of these individuals who have available capital tend to consult professional finance managers to talk more about how to shield a portfolio from various kinds of risk. Knowing about equity risks and calculating them will help many investors stay afloat in volatile markets and tough economic times.

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