Risk Types for Investors

Risk is one of the lesser understood terms - especially in the personal finance world.

Often, investors tend to think whatever has higher risk gives better returns.

This is not fully true.

Many times, investments that are very risky tend to give higher returns if things turn out well.

Risk means that there can be a loss or lower return. Risk means that something good might happen but also, something bad might happen.

So, the higher the risk, the higher the chance of something bad happening too.

Okay, so, now: let’s say you took a risk and the negative outcome happened.

What does that mean?

Many tend to assume this means you lost all your money.

Again, this isn’t necessarily true.

You had a certain expectation. If that expectation isn’t met, you can say the risk’s negative outcome showed its face.

So, let’s say you invested in an asset expecting a return of 15%.

But you got only 7%.

It’s lower than what you thought you’d get. So that’s a negative outcome.

There’s a certain type of risk called market risk. That can be further divided into three types:

Equity risk:

This risk refers to the risk arising from the constant up and down movement of stock prices in the stock markets.

Let’s say you bought a stock for Rs 100 today and your aim is to take this money out in 6 months.

6 months later, unfortunately, the stock’s price is down to Rs 70.

This is a risk.

Equity risk is one reason why many investors avoid investing in stock markets for short durations.

Interest rate risk:

This risk, as the name implies, is because of the change in interest rates.

While most of us might not be aware, interest rate changes can adversely affect bond prices.

Debt mutual funds invest in bonds among other assets.

Currency risk:

This risk arises when you’re investing across different countries.

Let’s say you invested in the US markets. You made good returns.

But while getting your money back into India, you encounter a very different US dollar - Indian Rupee exchange rate.

Because of this, in this case, you didn’t make the high returns you thought you would have.

This risk is called currency risk.

Liquidity risk:

Liquidity refers to the ability to turn your asset into money.

An asset that can be easily converted to money is called more liquid than something that takes longer to convert to money.

Example:

Your money is kept in a mutual fund, you can withdraw that in about 4 working days.

Also, your money is invested in real estate, it can take weeks or months to get money by selling it.

Here, mutual funds are considered more liquid than real estate.

Liquidity risk is the risk of not being able to convert your asset to money at the speed you expect it to.

For example, in the case of some stocks, sometimes, there are no buyers or sellers at the desired price.

At that point, it becomes tough to buy or sell that stock. This is an example of liquidity risk.

Concentration risk:

Concentration risk refers to the risk that arises from too much money being placed in one asset.

Let’s say you have a total of Rs 1 lakh to invest.

Of that, you invest a total of Rs 80 thousand in one stock, and the rest, you invest in a bunch of stocks.

This is an example of concentration risk.

Too much of your money is kept in one place. If something happens to that company that adversely affects its price, a very big chunk of your investment suffers.

What is the correct amount to invest to avoid concentration risk? There is no such level. It depends from investor to investor and asset to asset.

Credit risk:

Credit risk refers to investments in bonds.

Bonds in a way are investments in loans.

If the borrower runs into some kind of trouble and is unable to pay back the borrowed amount, it is called credit risk.

Credit risk is different for different people and organizations.

If an organization is reliable and is more likely to pay back its borrowed amount and interest, it is said that the credit risk, in this case, is low.

Inflation risk:

Inflation is constantly reducing the buying power of your money.

Today you can buy a bottle of milk for Rs 25. 10 years ago, it was much cheaper.

This is because of inflation.

Inflation risk is the risk that your return on investment might not be able to beat the inflation rate.

Let’s say an investment gives you a return of 5%. But, at the same time, let’s say the inflation is 6%.

In this case, you didn’t actually make any returns on your investment.

In fact, you lost 1%.

This risk of your investment not giving a return higher than inflation is called inflation risk.

Timing Risk:

Let’s say you suddenly made a lot of money - by selling some other asset or making some other massive gain.

Now you want to invest this money in the share markets for the long term.

Let’s say you invested the entire amount in one go.

But the times are such, the markets crashed or fell massively after you invested.

Now, your money is suddenly worth a lot less than you had invested.

This risk is called timing risk.

There are strategies to deal with this kind of risk.

In the case of mutual fund investments, it is advised to invest using STP (Systematic Transfer Plan).

Explore different strategies you can use to reduce timing risk.

Information Risk:

Information risk is, as the name suggests, the risk that arises from false or inaccurate information.

Wrong information leading to bad investments might seem to affect short-term investors more. But this isn’t entirely true.

Bad information can lead to bad decisions for long-term investors also.

Many investors continue investing in poor quality or ill-fitting mutual funds for years due to poor information being shared with them.

Make sure you deal with information that is accurate and free of someone’s ill intentions.

Risks come in all sizes and shapes. The risks we have discussed in this course so far are only a few of them.

We suggest you spend more time understanding different kinds of risks and taking steps to deal with them.

You will never be able to completely remove risk from any investment.

You can only prepare and be aware of them.