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Types of Investment Risks
Often people are not aware of the risks involved in the investments they choose to make. This makes them worried or confused. The key to investing wisely is to know the risks you are taking and how your investments are likely to perform within these risk parameters.
The risks associated with investments are mentioned in their document, brochure or prospectus. It is therefore important to go through these documents carefully and understand the risks involved. The fact is all investments carry a certain amount of risk. The type of risk may differ from investment to investment, making it all the more important to know about the different types of investment risks.
Systematic and Unsystematic Risks
Investment risks can be divided into two broad categories, namely systematic and unsystematic risks.
Systematic risk
Systematic risk is the type of risk that is not under your control and affects a large number of assets. Any new law that the government passes or any new regulatory announcement that affects your investments falls under systematic risk.
Unsystematic risk
On the other hand, unsystematic risk affects a very small category of assets. It is also called ‘specific risk’. For example, the price of a specific stock may get affected due to a fire at the company’s manufacturing plant.
Let us look at some of the other types of risks associated with investments.
Business risk
Business risk, also known as ‘stock specific risk’, pertains to the risks of a particular company or a stock. However, this risk may be specific to a sector as often companies pertaining to a specific sector have identical risks. For example, all sugar manufacturing companies will suffer if the sugarcane output is low in a particular year due to poor rainfall.
The risk is the possibility that the company may go bankrupt, leading to crashing of the stock price or an issuer of a bond not being able to pay the promised interest or principal amount. The reasons for this can be many from poor management to fraud to running out of capital. The easiest solution to avoid business risk is to diversify. For example, when you invest, you can diversify your portfolio by holding stocks of various companies instead of just one.
Currency risk
Currency risk is the risk that arises with the change in the value of one currency against other currencies. Let’s say you invest in US dollars, where 1 USD = ₹ 64. Now if the USD falls due to some reason, then the value of your investment will also fall. Currency risk persists for all investments done in any other currency than your home currency and is especially prominent in the case of short-term investments.
Credit risk or default risk
This especially concerns investors who invest in bonds and debt instruments. A good credit score or risk means that the company or institution will pay the promised principal and interest that they owe. Generally, government bonds hold the least amount of credit or default risk, whereas, bonds taken out by companies have higher credit risk but also offer a higher rate of interest. Typically, higher the default or credit risk, higher the given interest rate. Many rating institutions rate these bonds and debt instruments, helping investors determine whether the investment option is investment grade or junk.
Inflationary risk
This refers to the risk that your investments and cash flow will considerably reduce in purchasing power due to inflation. The best way to avoid inflationary risk is to invest in equities that give higher returns than inflation over the long-term.
Interest rate risk
Interest rate risk is the risk that the value of the fixed-rate debt instrument will decline due to the rise in interest rates. The fixed rate will become less attractive if the base rate increases.
Market risk
This is simply the risk you take when you invest in the stock market. It is taken as a form of systematic risk as it follows its own broad trends and cycles and cannot be avoided by diversification unlike business or stock specific risk. One way to ride through the market risk is to stay invested for a long-term period.
Management risk
Management risk usually comes into play when investing in a mutual fund or portfolio management services. The risk is that the fund manager may under perform with respect to the given benchmark. One way to avoid management risk is to invest in index funds. However, the downside or trade-off is that it will never outperform the market in terms of returns.
Liquidity risk
This refers to the possibility that you may not be able to sell and raise money from your investments when needed. Liquidity refers to the readiness to sell an asset. For example, stocks are very liquid, whereas your house is highly illiquid. The risk with illiquid assets like real estate or fixed term deposits is that they are not very easy to sell at the desired moment of time, if needed, due to lack of opportunities or lock in period.
Regulatory /legislative risk
This is when the lawmakers or regulators of a country pass new laws or announce regulations that may hurt your investments or the sector that you have invested in. For example, if the government takes out a law to limit the production and usage of non-renewable energy like thermal energy, it would adversely affect your investments in the stocks of all coal and thermal power companies.
Political/country risk
This usually refers to the risk that a country carries due to its unfavourable policies or social situation that may lead to increased loss of investment. For example, a company making profit but having operations out of politically sensitive areas like Africa or Middle-East may have lower valuation, therefore lower stock price, due to its country risk.
When you invest, you are exposed to a mix of these risks depending upon the type of your investment. Being aware of the risks associated with an investment and weighing the potential returns against the potential risk is important for making an investment decision. This is essentially the approach of risk-aware investing. The key is to analyse the potential risks to understand if they justify the potential returns.
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Not all risks are applicable to every investment. Read the brochure or offer document details carefully to understand the associated risks.
Prioritise your tolerance for investment risks. See which kind of risks you are more comfortable with, when deciding on investments.
Weigh the potential returns against the risks associated with the investment you are considering and then make a decision.
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