7 MinsJuly 12, 2021
“Successful investing is about managing risk, not avoiding it.” “The essence of investment management is the management of risks, not the management of returns.” This is what Benjamin Graham, the father of value investing, had to say about investment risk.
But what is investment risk? Risk refers to the probability of an investment outcome differing from what you expected. It represents a possibility of losing some or all the principal amount you originally invested.
Risk v/s reward
While no investment is safe, the risk varies from one investment to another. Usually, risk and returns are directly proportional to each other. But when you invest money to earn returns, you must assess the risk involved and take a calculated risk. The key is to be aware of the risks involved, and not invest blindly.
Being aware of the types of investment risks can help you make informed investment decisions.
Primarily, risks are broadly classified as Systematic Risk and Non-systematic Risk.
Systematic Risk – This is a macro level broad-based risk, which may not be in the purview of your control and, hence, a non-diversifiable risk. It is very much integrated with the market; therefore also called the market risk. The COVID-19 pandemic and resultant economic uncertainty, the global recession, financial crisis of 2008, changes in laws and policies that have larger ramifications on the society, etc. are some examples of systematic risk. The way to reduce this risk is by staying invested for the long term.
Non-systematic Risk – This risk is at the micro-level and unique to a particular industry and/or company within the industry. So it is specific and, in a sense controllable, by the investment decision you take. It can be mitigated by investing across diverse sectors and businesses. Some of the common examples of non-systematic risks are, patent issues faced by a pharmaceutical company; the food and drug administrator banning a particular drug; slump in the housing sector, etc.
Below are some important investment risks:
Inflation Risk – Inflation erodes the purchasing power of money. With rising inflation, you can purchase fewer goods and services. If the value of your investments does not counter inflation, you may not be clocking an effective real return, which is a risk.
Fixed-income instruments are usually more impacted by inflation risk because there is no surety that coupon rate or interest earned would keep up with or beat inflation.
For example, if a 1-year bank fixed deposit earns you interest @ 5.50% p.a., but CPI inflation on an average has been 6.00%, you are earning effectively earning -0.47% real returns [(1 + 0.055)/(1 + 0.06)-1]. Equity as an asset class can beat inflation, provided you remain invested for the long term.
Interest Rate Risk – The value of debt securities and fixed income investments are dependent on the underlying interest rate scenario. When interest rates move up, the value of debt securities goes down and vice versa. Over a long period, interest rates could see several cycles of ups and downs. So a debt portfolio could see fluctuation in its value.
One way of managing this risk is to invest in a shorter duration portfolio in a rising interest rate scenario.
Credit Risk – When investing in fixed-income instruments and debt securities, you expect to get back the principal amount plus the coupon rate/interest or capital appreciation at maturity. However, if the issuers of such securities delay or default on their obligations then it is a credit risk for the investor. In times of economic uncertainty, the credit risk usually intensifies in the case of private issuers.
Keep in mind, that if the coupon rate of the bond or interest rate offered on a fixed deposit is usually high, it could be an indication that the credit risk is high. Hence, always check the credit ratings of such instruments before investing.
To keep the credit risk of your investments low, opt for government-backed securities and high credit-rated securities and in turn portfolios (AAA or equivalent).
Liquidity Risk – This is the risk of not being able to redeem your investments when you want to. It is possible that the investment may have a lock-in period or it could be the issuer is unable to repay you. The liquidity of an instrument may change depending on the market conditions. In stock market investing, it may be possible that you are unable to sell your shares quickly at a competitive price due to low trading volumes. Thus liquidity risk is also called marketability risk. To mitigate this risk, it is important that you invest in stocks and bonds of companies that are actively traded, and hence always in demand.
Re-investment risk – This is when you are unable to reinvest the proceeds received from an earlier investment, at a rate comparable to the current interest rate. To put it simply, the coupon or interest on the new security may be lesser than the one you had earlier invested in. You may have typically experienced this while renewing your bank fixed deposit, where you discover that interest rates have moved down compared to earlier.
Usually, bonds that are long term in nature and offer high coupon pay-outs, are exposed to high re-investment risk. To manage this risk, hold a portfolio of fixed-income instruments and debt securities with diverse maturities.
[Also Read: Invest Wisely]
Concentration Risk – When your investment portfolio is skewed to one particular asset class, one or two sectors, a particular theme or one or two issuers of securities, then it is a concentration risk. You may not earn a worthy return if the asset class or sector underperforms. To alleviate this risk, it is important to follow asset allocation and diversification.
Currency Risk – This risk arises due to changes in the foreign exchange rate and when you have investments in any other currency apart from your home currency. If the value of the foreign currency falls, it weighs on your return on investments as well.
Business Risk – This risk is specifically associated with the business of the company you may have invested in. For instance, the company may lose market share to the competition, suffer losses, run out of capital, face problems on account of poor management or even face bankruptcy. These have a bearing on your investments. Thus for risk mitigation, it is necessary to diversify across businesses and industries and pay attention to the management quality and fundamental analysis.
Political Risk – The political scenario, policy decisions of the government, the administration/governance, how the dispensation handles multi-lateral ties with other nations and taxation policies/laws are some of the factors that constitute a political risk and weighs on the investments you make. To mitigate this risk (along with country-specific risks), diversify investments across the geographical boundaries of your country.
Fund Management Risk – This risk kicks in when you invest in mutual fund and/or portfolio management schemes, and a fund manager deviates from the stated investment strategy. If the fund manager fails to generate alpha or underperforms vis-à-vis the respective benchmark index, it is a risk. This can be mitigated by investing in mutual fund schemes and/or portfolio management schemes that follow robust investment processes to achieve the stated investment objectives.
There are various risks when it comes to investing. As a prudent investor, it is necessary to evaluate the investment rationally and take calculated risks as you seek to build wealth. Click here to explore investment options available with Axis Bank.
Disclaimer: This article has been authored by PersonalFN, a Mumbai based Financial Planning and Mutual Fund research firm. Axis Bank doesn't influence any views of the author in any way. Axis Bank & PersonalFN shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision