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All investments carry risk. They have to be identified and steps must be taken to minimise them. If the investment is overtly risky, it might lead to complete loss of capital.
Let us look at some risks applicable to investments:
Liquidity risk: An investment is said to be liquid if it can be quickly converted into cash. A liquidity risk refers to the possibility of the investor being unable to realise the value of the investment when required. This may happen because the security cannot be sold in the market or is prematurely terminated or because the resultant loss in value is huge.
Purchasing-power risk: When prices shoot up, the purchasing power of your money plunges. Relatively safer fixed-income investments such as bank deposits and small-savings instruments are more prone to inflation risk because rising prices erode the purchasing power of your capital. Gold is the biggest hedge against inflation (or purchasing-power) risk.
Interest-rate risk: Fluctuating interest rates are a common phenomenon with the ensuing impact on investment values and yields. The 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 movements in interest rates. If you have invested for three years in an instrument yielding 8 per cent annually and interest rates move up to 9 per cent, one year in a similar instrument may offer 9 per cent. But because of the lower yield of the earlier instrument, the value of your security is reduced. The interest-rate risk plagues debt mutual funds. With bonds, the price of a bond is inverse to interest-rate changes. So if the interest rate moves up, bond prices slide, resulting in the lower Net Asset Value of debt funds.
Market risk: Market risk constitutes the risk of movement in prices of securities due to factors that affect the market as a whole. Market forces determine the price of a security based on demand and supply. In a bearish market because of limited demand, prices of blue chips too are subdued. Similarly, in a bullish market, penny stocks register an upward price trend.
Default risk: This risk refers to non-payment of interest - or both the principal and the interest. With unsecured instruments, this risk is great. Since there is no underlying security, one can do nothing except take legal recourse. So one needs to look at credit ratings of a company before investing in company deposits or debentures.
Hence, such enterprises generally or typically command high returns.
Political risk: Political risk could be due to policy changes, government instability, international events, etc. It is external to any business and is rather difficult to mitigate. For instance, the threat of war causes panic in financial markets.
Exchange rate risk: This is mainly for companies that have exposure abroad (have to make payments in foreign currencies). Any changes in the foreign-exchange rates bear on profitability. India is now faced with a high degree of volatility in forex.
How to manage risks: Not all these risks may be applicable simultaneously to any single investment. Nevertheless, often 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 lower degree of business risk.
As seen from the table, equity carries the highest risk. As a result, it offers the possibility of higher returns. Traditional instruments (bank fixed deposits and gold) are less risky overall.
Investment in post-office deposits and government bonds are risk-free as they have the sovereign guarantee. Bank FDs and bonds and debentures carry lower risks on many counts but are subject to purchasing-power or inflation risks.
Gold, however, is affected by exchange rate risk.
Real estate has the highest liquidity risk.
Where risk is great, returns can be expected to be high. Hence, manage your investments to achieve the right balance between risk and return.
The author is a freelance writer
