The term RISK generally refers to the volatility of a particular security. Investments typically have an associated risk based upon their exposure to markets and the fluctuations within them. Risk is differentiated from “uncertainty” because it is measurable; therefore, investors must methodically research the securities they invest in to mitigate loss. Their research and analysis are crucial in deciding what kind of position, if any, should be taken.
Markets price securities to incorporate all available information, and react quickly to incorporate the effects of new information into the price of securities. Investors, however, can only predict future information and its effect on the pricing of securities.
Risk is one of the most fundamental aspects of investing and lies within the core of research. Investors seek securities that will offer a high return without losing principal investment. The investments often deemed “risky,” in many cases, are subject to greater return than those considered risk-averse. It is this concept that leads money managers to seek out risky investments that they believe will yield a high return.
Without knowing how the overall economy and its various macro-economic factors, the company or underlying assets tied to the security, and how the investor’s own financial situation will perform and change, the investor has no way of accurately predicting the performance of any security or class of securities.
1) Default risk
The risk of non-payment refers to both the principal and the interest. For all unsecured loans, e.g. loans based on promissory notes, company deposits, etc., this risk is very high. Since there is no security attached, you can do nothing except, of course, go to a court when there is a default in refund of capital or payment of accrued interest.
So it’s always good to look at the CRISIL / ICRA credit ratings for the company before you invest in company deposits or debentures.
2) Business risk
The market value of your investment in equity shares depends upon the performance of the company you invest in. If a company’s business is doing excellent then the company performs well & the market value of your share can go up sharply & vice versa. When you invest money in Companies with poor financials & poor managerial decisions, there is always a possibility that you may lose your hard earned money.
3) Liquidity risk
Money has only a limited value if it is not readily available to you as and when you need it. In financial jargon, the ready availability of money is called liquidity. An investment should not only be safe and profitable, but also reasonably liquid.
An asset or investment is said to be liquid if it can be converted into cash quickly, and with little loss in value. Liquidity risk refers to the possibility of the investor not being able to realize its value when required. This may happen either because the security cannot be sold in the market or prematurely terminated, or because the resultant loss in value may be unrealistically high.
Current and savings accounts in a bank, National Savings Certificates, actively traded equity shares and debentures, etc. are fairly liquid investments. In the case of a bank fixed deposit, you can raise loans up to 75% to 90% of the value of the deposit; and to that extent, it is a liquid investment.
Some banks offer attractive loan schemes against security of approved investments, like selected company shares, debentures, National Savings Certificates, Units, etc. Such options add to the liquidity of investments.
The relative liquidity of different investments is highlighted below:
When prices shoot up, the purchasing power of your money goes down. Some economists consider inflation to be a disguised tax. Given the present rates of inflation, it may sound surprising but among developing countries, India is often given good marks for effective management of inflation. The average rate of inflation in India has been around 4-5% p.a. during last decade.
Ironically, relatively “safe” fixed income investments, such as bank deposits and small savings instruments, etc., are more prone to ravages of inflation risk because rising prices erode the purchasing power of your capital. “Riskier” investments such as equity shares are more likely to preserve the value of your capital over the medium term.
5) Interest rate risk
In this deregulated era, interest rate fluctuation is a common phenomenon with its consequent impact on investment values and yields.
Interest rate risk affects fixed income securities and refers to the risk of a change in the value of your investment as a result of movement in interest rates.
Suppose you have invested in a security yielding 8 percent p.a. for 3 years. If the interest rates move up to 9 per cent one year down the line, a similar security can then be issued only at 9 percent. Due to the lower yield, the value of your security gets reduced.
6) Political risk
The government has all the powers to control the economy; it may introduce legislation affecting some industries or companies in which you have invested, or it may introduce legislation granting debt-relief to certain sections of society, fixing ceilings of property, etc. One government may go and another comes with a totally different set of political and economic ideologies. In the process, the fortunes of many industries and companies undergo a drastic change. Change in government policies is one reason for political risk.
Whenever there is a threat of war, financial markets become panicky. Nervous selling begins. Security prices plummet. In case a war actually breaks out, it often leads to sheer pandemonium in the financial markets. Similarly, markets become hesitant whenever elections are round the corner. The market prefers to wait and watch, rather than gamble on poll predictions.
7) Market risk
Market risk is the risk of movement in security prices due to factors that affect the market as a whole. Natural disasters can be one such factor. The most important of these factors is the phase (bearish or bullish) the markets are going through. Stock markets and bond markets are affected by rising and falling prices due to alternating bullish and bearish periods: Thus:
• Bearish stock markets usually precede economic recessions.
• Bearish bond markets result generally from high market interest rates, which, in turn, are pushed by high rates of inflation.
• Bullish stock markets are witnessed during economic recovery and boom periods.
• Bullish bond markets result from low interest rates and low rates of inflation.
How to manage risks
Not all the seven types of risks may be present at one time, in any single investment. Secondly, many-a-times the various kinds of risks are interlinked. Thus, investment in a company that faces high business risk automatically has a higher liquidity risk than a similar investment in other companies with a lesser degree of business risk.
It is important to carefully assess the existence of each kind of risk, and its intensity in whichever investment opportunity you may consider.
However, let not the very presence of risk paralyse you into inaction. Please remember that there is always some risk or the other in every investment option; no risk, no gain! What is important is to clearly grasp the nature and degree of risk present in a particular case – and whether it is a risk you can afford to, and are willing to, take. Success skill in managing your investments lies in achieving the right balance between risks and returns. Where risk is high, returns can also be expected to be high.
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