Tuesday, August 23, 2011

Understanding Investment Risks

For a common man, the term 'risk' simply means 'uncertainty' often for an unfavourable result. But for a person from finance, the term risk assumes a special meaning, referring to the “variability in expected returns'. In simpler words, in indicates the chance that an investment's actual return will be different than the expected return.
In this article, we will introduce you to the different types of risks involved in the world of investments. This knowledge would help you to better understand the different risks you are exposed to whenever you are making any investments. To begin with let us classify investment risks into two types depending upon whether we have any control in managing them. Investment Risks are broadly classified into (i) Systematic risks and (ii) Unsystematic Risks.
Systematic risk: Systematic risk relates to factors that affect the overall economy or the securities market and hence is also known as 'market risk'. It is something which is beyond the control of an investor and cannot be avoided. The common systematic risks affecting investments are:
  1. Interest-Rate Risk: This type of risk describes the risk that the value of security will go down with the changes in the interest rates. This risk directly affects debt products like Government bonds, Certificates of Deposits, Treasury Bills, etc. For example, when interest rates increase, the old bond prices fall since the investors will now prefer the newer bonds offering higher interest rate. Also, in the case of falling interest rates, the bonds that are maturing or paid off before maturity have to be re-invested at the lower interest rates in the market. The risk is higher for securities of higher duration / maturity period.
  2. Inflation Risk: The increase in the price of goods and services, in other words, the cost of living reduces the purchasing power capability. This is termed as the inflation risk. This is something we all are experiencing in India where the value of money has decreased and the returns or interest incomes are insufficient to counter the rise in price levels, and also the value of investments have eroded.
  3. Currency Risk: It is a form of financial risk that arises due to the change in the exchange rate of one country in relation to another. Cross border investors or businesses are impacted due to currency risk if they transact in a foreign currency, invest in international funds or borrow/lend in a foreign currency.
  4. Liquidity Risk: Liquidity risk arises if one is unable to buy or sell funds quickly enough to minimize or mitigate losses. Sometimes one may not be able to sell an investment if there are no buyers for it or even if the credit rating for the institution falls. Liquidity risk is generally the highest in case of shares of small companies.
  5. Socio-political Risk: This type of risk is caused due to the possibility of an unrest or war in a particular region that may affect the investment markets. For example, the attack on the WTC and Pentagon in September 2001 had caused a wide scale disruption of the financial system. Similar kind of events may pose great danger. Similarly, if one is investing in another market, the change of government can also cause socio-political risk if that government brings about unfavourable changes in the system.
  6. Regulatory Risks: Risk arising due to change in regulations which adversely impact businesses. It also includes Tax Risks which directly impact the revenues of the companies.
  7. Volatility Risk: It is the day-to-day fluctuations in the prices of stocks and bonds.
Unsystematic Risk : Un-systematic risk is the risk limited only to a small number of companies or specific industries or securities and is uncorrelated to the markets. The risk is inherent in the nature of such securities and thus it is also known as 'specific risk' or 'diversifiable risk' since the investor can avoid such risks by limiting his/her exposure to such investments. Diversification is a good way to mitigate this risk since if you are investing into different asset classes and different securities, specific risks associated with each of them has little impact on your overall portfolio. The common Unsystematic risks are:
  1. Management Risk: A wrong decision taken by the company management, internal disputes or even some external situations can cause management risk, also known as company risk. Such steps affects the performance of the company and that in turn, would affect the value of an investor's holdings in that company. It is a case when the management puts his personal interests before the company interest. For example, in the case of Satyam, it was a well respected company till the management revealed about the financial mess it was in. The investors lost crores as a result of this news.  
  2. Credit Risk: Credit risk, also known as default risk, is a situation when the bond's issuer's likely failure in paying the interest as scheduled or failure in paying the principal amount upon maturity. Credit risks are calculated based on the borrower's overall ability to repay the due amount on time. The higher the credit risk, the higher the interest rates that will be demanded by the investors for lending their capital.
  3. Business Risk: It is the uncertainty of risks associated with the company's operating environment which impacts the ability of the company to have adequate cash flow to meet its operating expenses. A business risk may arise due to a circumstance or factor that may have a negative impact on the operation or profitability of a given company.
Behavioural Risks:
Apart from the investment risks arising out of the securities, there are also many risks arising out of the behaviour or actions or inactions of the investor himself. Such risks arise often due to involvement of emotions in investing, especially the emotions of 'fear', 'greed' and 'hope'. Further, risks may also arise due to lack of investment expertise or knowledge, especially when you are investing in high risk products like direct equities or derivatives. Significant investment risks also arise by not regularly reviewing your portfolio or by following an asset allocation unsuited to your profile. The behavioural risks are in fact more crucial to understand in investing, the benefits of which can help us make much smarter decisions.

Risk is universal:
As investors we need to understand that there is nothing truly risk-free in this world. Risk is omni-present in every choice, action we take in life and in every place at all times. Talking of investments, what really matters is the trade-off between risk & return. A smart investor is one which understands this trade-off and uses it to his advantage. In the end, it doesn't really matter if you are right or wrong, but what matters is by how much you have gained or lost.

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