Investing is all about taking risk. There is a direct correlation between the two. Higher the risks higher are the returns and vice-versa. Hence, it is critical to know what is meant by risk.
Risk, in general, means ‘exposure to any hazard.’ However, in the world of investing – the definition of risk is slightly different. Risk in the investing world means the possibility of what is actually earned as return could be different from what is expected to be earned. The deviation between actual returns and expected returns is called risk.
Here one may ask if the returns from an investment remain unchanged over time, there would be no risk. It may be a good hypothetical scenario, but in the real world there are no such investments. Even the returns on government securities change over a period. Risk persists everywhere.
We simplified the risks into 8 parts so that the investor can better evaluate their investments based on them.
1. Inflation risk
Inflation is known to be a silent killer. It is a fact that things we purchase today are going to cost us more in the years to come. The purchasing power of money is only declining in time to come. Thus, from an investment point of view, it is important that we consider inflation risk on our investments too.
Inflation risk represents the risk that the money received on an investment may be worth less when adjusted for inflation. For instance, Mr. A was earning Rs. 6,000 per month on his lump sum fixed deposits. This was sufficient for him to buy household provisions. However, due to inflation of 10 per cent there was a general price rise of 10 per cent in goods. Now the monthly cost of provisions would be Rs. 6,600. So, Mr. A either needs to cut back on his expenses or shift to another investment class where the returns generated would be Rs. 6,600.
The inflation risk is highest in the fixed return instruments like bonds, deposits and debentures. Inflation risk has a particularly adverse impact on the income of retired people. This risk can be handled by way of tactical allocation of investments. Inflation hedged funds or short term debt funds are good options to generate higher than inflation rate returns.
2. Default/Credit risk
Default risk or better known as credit risk is the probability of borrowers not being able to meet their commitment on paying interest or principal as scheduled. The ability of the issuer of the debt instrument to service the debt may change over time and this creates default risk for the investor. For instance, a company may have a strong balance sheet when the investors have taken exposure. However, either the macro-economic factors or micro-economic factors have resulted in poor financial health of the company. This may result in default risk.
The sovereign government bonds may not have default risk. But the rest of the instruments have some degree of credit or default risk associated with it. This is measured using the credit rating assigned to a debt instrument. To make it easier for the investors, credit rating agencies give ratings based on analysis (easily understood even by retail investors). However, despite such ratings there have been cases of defaults occurring. The simple way to tackle such default risk is holding a diversified portfolio of bonds.
3. Liquidity risk
Liquidity risk has been one of the prime reasons why there has been more inclination towards the financial assets. Physical assets relatively have lower liquidity compared to financial assets. While in equity and mutual funds one can sell the holding at market rate, in case of physical assets one needs to find a buyer, derive a rate and then the trade happens. Liquidity risk refers to the ease with which an investment can be bought or sold in the market and an absence of liquidity in an investment. It is due to the liquidity risk that the investor may not be able to sell his investment when desired or it has to be sold below its intrinsic value. In few cases there are high costs to carrying out transactions affecting the realisable value of the investment. The market for corporate bonds in India is not liquid, especially for retail investors.
4. Reinvestment risk
Reinvestment risk arises from the probability that income flows received from an investment may not be able to earn the same interest as the original interest rate. The risk is that intermediate cash flows may be reinvested at a lower return compared to the original investment.
The reinvestment rates can be high or low, depending on the levels of interest rate at the time when the coupon income is received. This is the reinvestment risk. To make it simple, remember that in the case of bonds, if the interest rate rises, reinvestment risk reduces and vice-versa. Here, rate and risk are indirectly proportional to each other.
5. Business risk
Business risk is the risk inherent in the operations of a company. It is also known as operating risk, because this risk is caused by factors that affect the operations of the company. For instance, there was a company which used to manufacture analogue speedometers which are now replaced by the digital ones. The business was likely to get affected. Similarly, there are other operational risks like the rise in raw material prices, sudden change of regulations, etc. Holding a diversified portfolio is a good way to tackle such kind of risk.
6. Exchange rate risk
Exchange rate risk is incurred due to changes in the exchange rate of domestic currency relative to a foreign currency. When a domestic investor invests in foreign assets, or a foreign investor invests in domestic assets, such investments are subject to exchange rate risk. For instance, a foreign investor invests USD 1000 in an asset in India when the exchange rate was Rs. 60 per USD. So, the investment is Rs. 60,000. A year later, the investment gives a return of 10 per cent. So, the invested amount now becomes Rs. 66,000. However, the INR depreciates during the same period and now becomes Rs. 67 per USD. So, if we convert the same to USD, Rs 66,000 becomes USD 985. Despite asset class generating returns of 10 per cent, the depreciation of INR has resulted in loss due to exchange rate fluctuation.
7. Interest rate risk
Interest rate risk refers to the risk that bond prices will fall in response to rising interest rates, and rise in response to declining interest rates. The relationship between rates and bond prices can be summed up as follows.
· If interest rates fall, or are expected to fall, bond prices increase.
· If interest rates rise, or are expected to rise, bond prices decline.
Bond investments are subject to volatility due to interest rate fluctuations. This risk also extends to debt funds, which primarily holds debt assets.
8. Systematic and unsystematic risk
Systematic risk refers to those risks that are applicable to the entire financial market. These risks are also known as un-diversifiable risks because they cannot be eliminated through diversification. Systematic risk is caused due to factors that may affect the economy or markets as a whole, like changes in government policy, external factors, wars or natural calamities.
Unsystematic risk is the risk specific to individual securities or a small class of investments. Hence, it can be diversified away by including other assets in the portfolio. Unsystematic risk is also known as diversifiable risk. Credit risk and liquidity risks are unsystematic risks.
Conclusion: Investment is all about taking risk. However, if one studies the unsystematic risks properly and handles in a tactical manner, the investment path becomes comforting.
Pro Tip: Inflation is a silent killer. Consider Inflation as the top-most factor to counter while setting long term financial goals.