As an investor, it is crucial to fully understand the various types of risks along with those risks that are significant relative to a particular investment and from an individual perspective.
Ideally, there are two types of risks: systematic risks and unsystematic risks. While systematic risks affect all investments across asset classes, unsystematic risks are specific only to a particular asset class. Within these two, fall various types of risks, which are mentioned below:
Default risk: It arises out of non-payment of interest and principal amount. It is something that an investor should be wary of. For example, promissory notes have a high degree of risk of default, since there is no security attached. There is a risk of default if you have invested in debentures or bonds, and the company fails to pay timely interest.
Business risk: This is a risk arising out of investing in a business. For example, investment in equity shares or real estate is investing in a business. If the company fails to generate decent profits and the business is unsustainable, there is a risk of loss of dividend income and principal capital. Similarly, if property prices fall or are too volatile, one may not recover anything.
The market value of your investment in equity shares depends upon the performance of the company you invest in. If a business goes bankrupt, one’s share in the business will generate nothing.
Liquidity risk: Liquidity is the ability of an asset to get converted into cash. If an asset can be quickly converted into cash with minimal loss in value, then it is considered highly liquid. For instance, bank deposits, post-office deposits, gold, and equity shares of blue-chip companies are considered fairly liquid as opposed to real estate, land parcels, commercial property, or works of art, among others.
An investment should ideally be safe and profitable as well as reasonably liquid.
Purchasing power risk: Inflation due to the rise in prices of items of consumption means one can buy less with money than what was previously possible. In other words, when prices shoot up, the purchasing power of your money goes down. Relatively safer investments that earn 7-8% cannot beat inflation if it is at 10% annually. However, assets such as equities and real estate can beat a 10% inflationary rise in the long term, and generate a return that is in excess of the inflation increase.
Interest rate risk: When an investor invests in a bond or debentures; or loans someone, one draws interest income. Interest rate risk refers to the risk of the possibility of generating lower income on fixed-income securities due to changes in interest rates.
Considering the present scenario, interest rates are hardly stable, and fluctuation is a norm. For example, if you have invested in a bond that pays 9% annually, and if there is a new bond in the market that promises to pay 10% annually, then the price of your bond will reduce; and as an investor, you lose money. Interest rate risk affects fixed-income securities. Many a time companies default on their obligatory interest payments – which also is a risk.
Political risks: These arise due to changes in government policies and regulations. These have the potential to affect the prospects of companies and industries; and, therefore, their ability to earn decent profits.
As the government has extraordinary powers to impact the economy, it may introduce laws affecting some industries or companies in which you have invested; or it may introduce legislation that grants debt relief to certain sections of society, and fixes ceilings of the property.
Similarly, a change in government after elections also adds to political risk, as there may be new rules and regulations.
Threat of war, elections, and international political developments, just to list a few, all have a bearing on one’s investment income.
Market risks: Stock markets and bond markets are affected by rising and falling prices due to alternating bullish and bearish periods. Market risk is the risk due to movement in stock and bond prices as a result of factors that affect the market across the board.
It is important to carefully assess the existence of each kind of risk, and its intensity in whatever investment opportunity you may consider. Analyse well the risk and returns trade-off in any investment proposal and select judiciously.
All investments carry some form of risk. While risks cannot be wished away, they can be mitigated or minimised to an extent. However, it is important to note that when it comes to investments, no risk translates as no gain!
Rajiv is an independent editorial consultant for the last decade. Prior to this, he worked as a full-time journalist associated with various prominent print media houses. In his spare time, he loves to paint on canvas.