What Are The Types of Risks One Must Be Aware of While Making Investments?
In a general discussion, our in-house consultants revealed that most of the investors they encounter seek suggestion for ‘limited risk and high return funds.’ They disclosed that “There is no such thing as free lunch. If you are expecting gains from the market, you have to stomach volatility.” “We would like to advise our investors that we praise the concept of investment as it helps in achieving the future financial goals.
But accomplishing both high return expectations and security of amount simultaneously, is only the best case situation here.” There is always one or the other type of risk related to investing. According to Warren Buffett’s thought - “Risk comes from not knowing what you are doing.” So, for the sake of damping the effect of uncertainties, let us identify the distinctive types of risks associated with the equity and debt investments.
What is Risk?
Typically, risk includes exposure to some type of danger that can potentially causes loss or injury. But in the investment world, it has only one meaning - losing the principal amount. Technically, risk may be taken as the degradation of return. So, the difference between the expected return and the actual return (when the actual return is less), or the uncertainty of that return becomes the “Risk” for an investor. Although there are innumerable risks related to investment, but here is a brief guide to the primary focal points.
Interest Rate Risk
It is the risk of losing money that arises due to the change in the interest rates. This type of risk is intimately related to debt investments like bonds. The prices of bonds fall down as the interest rates go up and vice versa. Securities that offer a fixed rate of return expose the investments to interest rate risk. An unexpected change in the interest rates may negatively affect the value of the investment at times.
To understand inflation risk, let us first find out what is inflation. Inflation endures a situation where the purchasing power of your money declines over time. This means same amount of money will buy fewer goods or services. Inflation risk is the loss of purchasing power of your fund because the value of the investment could not keep up with the inflation. Shares and convertible bonds provide some protection against inflation over the long term.
Suppose you invest in a fixed deposit today and earn a 10% interest on it in a year. But the inflation for the year you invested has been 8%. Keeping the purchasing power in mind, your real rate of return comes down to 2% because of inflation.
Credit Risk (Default Risk)
This type of risk arises when the company or individual you have given credit to fails to make the obligatory interest rate payments and/or principal repayment on its debt. Higher credit risk typically means higher interest rate on the bond. Difficult foreign exchange policies sometimes become a factor that initiate credit risk.
We should be cautious while investing in infrastructure bonds or company fixed deposits to avoid credit risks. In this regard, credit ratings offered by eminent rating agencies (CRISIL) can be beneficial. If you go by their advice, government bonds are pretended to have lowest credit risk (but not zero), while low rated corporate deposits are prone to high credit risk. In fact even a bank FD has credit risk, as only a maximum of Rs. 1 lakh is guaranteed by the Government.
Reinvesting principal or income at a lower interest rate gives rise to the loss known as reinvestment risk. Let’s assume you invested in a bond with 5% yearly interest. If in case the interest rate reduces to 4% in 1 year your regular interest payments will be reinvested at a lower rate. This risk also applies if the bond matures and you reinvest the principal at a reduced rate than 5%.
Liquidity risk is a consequence of inability to easily convert any asset into cash as and when required. This risk restricts the transaction due to limited opportunities. Insufficiency of either buyers or sellers against the selling orders or buying orders respectively, gives rise to the liquidity risk. Selling real estate can be a compelling example of liquidity risk. It can be difficult to sell a property at any given moment should the need arise. This might force the investor to sell the asset at discounts.
As the name suggests, market risk is the side effect of movement in the asset prices, interest rates and market volatility. These risks decline the value of an investment because of the economic or other events that manipulate the entire market. This risk affects all the financial instruments in the same manner. For instance, natural disaster can be a factor that would affect the whole market symmetrically.
The value of our investment in any asset directly relies on the performance of the company, in which we have invested. Business risk is the measure of risk associated with the company’s performance to which the asset belongs. This risk specifically highlights the possibility where the issuer of a particular asset is unable to pay the interest or the principal amount. Poor management or bankruptcy of the company may cause business risk. In general, all the companies in the same sector undergo similar types of business risk.
Currency/Exchange Rate Risk
Currency risk poses a threat to the ones who own foreign investments. The fluctuation in the exchange rates i.e. the change in price of one currency against another provoke the loss of money.
Suppose an Indian investor need to convert his profits from foreign assets into Indian Rupee. If the rupee is strong, subsequently the value of a foreign asset purchased on a foreign exchange will decline for him. However, if the rupee is weak, the value of the Indian investor's foreign assets will rise.
Risk emerging due to unfavorable government action or social changes and resulting in a loss of value of the financial instruments is called political risk. Social stability and the economic environment are largely affected by the government policies. We must watch for political stability and business friendly policies before investing. This risk is often seen in sugar or oil and gas sector.
When a country is unable to keep its debt obligations and defaults it faces the loss of value for all of its financial investment instruments. For example, all the stocks, mutual funds, bonds and other investment instruments of a country with a critical fiscal deficit are severely affected. Emerging economies are considered comparatively more risky than developed nations.
Volatility is the most underrated and least understood type of investment risk. All of us are aware of the fluctuating equity prices on daily basis. Investors must note that volatility of the market may eat away their portfolio value. Volatility risk can be measured by calculating the standard deviation of the returns with respect to the average return of the market index.
Investment Tips and Tricks
An investor must be on toes to bear uncertainties/risk related to every investment opportunity. The only points that make difference are the factors and degree of the risk that arrives. Recognizing the types of risk associated with your investments will avoid the dicey situations to great extents! The fundamental concepts behind each type of risk will make you confident over your investment choices. But if you are still confused on how to build a better portfolio that justifies your risk taking capabilities, connect with us. We assure you the most ethical guidance!