Investment Risks

5 Major Investment Risks You Need To Assess Before Investing Your Money

How many times have you heard people call investing or trading in the stock market, gambling? It’s madness when they tell you that bonds and fixed deposits are safer and has no risk.

Let me tell you something no financial asset, bonds, debts or shares, is 100% risk-free. They all carry some level of risk.

“But aren’t government bonds considered risk free?”

Yes, but that’s because the existing notion is that the government will pay it back one way or the other. For eg., by raising taxes, cutting public spending or even printing more money. However, that doesn’t mean the government can’t default. In fact, situations may occur when it may consider defaulting as a more preferable option as opposed to doing any of the above.

Another aspect to look at it is that, if you hold the government bonds till maturity then you may consider it safe. But if you sell it prematurely in the bond market, you may have to sell it at a lesser value thereby losing money.

That said, the chances of the government defaulting on bonds is extremely less. It’s by far the safest investments you can make. No wonder why everyone considers it safe.

So back to the main topic. Every financial asset you may hold carries some level of risk. Therefore, it’s highly essential that you understand what are the various kinds of risks. This will put you in a much better position to evaluate various investment decisions.

Let’s know more about these risks. First, we will talk about the two broad risks: unsystematic risk and systematic risk. 

Unsystematic Risk:

Every time someone asks you to invest in multiple stocks or across multiple securities like bonds and mutual funds, they are asking you to do it to avoid unsystematic risk.

 This is the sort of risk that’s inherent to a company or an industry. For eg., the airline industry is a highly regulated one. That means that a sudden change in regulation may hurt your investment. Let’s say the government decides to hike taxes on fuel or decides to increase fare restrictions for the airlines, all the airline stocks would fall heavily.

So if you have invested all your money on airline stocks, then this scenario would eat away most, if not all, of your investment.

On the contrary, if you had also invested in banking stocks and tech stocks, this scenario wouldn’t have hurt your portfolio as much because fuel costs and airline fares have no impact on banking and tech industry.

This is why diversification is so important in order to reduce unsystematic risk.

Other kinds of unsystematic risk are new competitors, technology advancements, change in management, product recalls etc.

Systematic Risk :

Remember that by diversifying you can reduce unsystematic risk? Well, you can’t reduce systematic risk by doing that.  Why? Because this sort of risk affects the entire market and the economy, and not only certain industries and companies. Let’s say you have a well-diversified portfolio of stocks of multiple industries. But what if the economy is hit by a recession? It would impact the entire economy. 

The only way to reduce this risk is to invest across multiple asset class such as fixed income groups (FD, bonds etc.). For eg., RBI decides to increase the interest rates. This will hit various industries because of the increase in production and operational costs. So no matter how diversified your portfolio is across various industries, your portfolio will suffer.

However, this rate hike will make debt market more attractive for investment. Hence if you have invested in the debt market, you will be able to enjoy higher returns despite losing some money in the stock market.

Now that we have covered both the broad risks, let’s get into the other kinds of risks that you would need to consider.

Credit Risk :

This type of risk exists in the debt market, especially with the bonds. This is the risk that the borrower will be unable to pay the principle and/or the interest amount to the investors. Whether it’s a government bond or a corporate bond, both carry this risk.

As I stated above, a government bond will carry a much less credit risk and therefore will pay you a lower return. On the contrary, a corporate bond carries a higher credit risk and will pay you a higher return.

So how would you know how risky a bond is? Simple. Just check the ratings given by any government or private credit rating agency. CRISIL is one such globally renowned credit rating agency. 

Liquidity Risk :

The risk that you won’t be able to sell your investment at the fair value or be able to sell if when you want to.

    Let’s say you want to sell the shares of a banking company which has recently gotten involved in a loan scam. Naturally, the share prices will fall hard and fast. Out of panic, you would end up selling your shares at whatever price you can get in order to avoid losing out all of your invested money.

   On the other hand, it could also happen that NSE and SEBI may block the trading of this stock. In this case, you are now stuck with your stock. You can’t even sell them and take back your money.

There is no real way of escaping this risk. All you can do is ensure you have analyzed the company in-depth before investing money in its stock.

 

Foreign-Exchange Risk :

This risk applies only when you hold assets in a different currency than your home currency. Let’s say you own a real estate property in U.S.A. Any return you receive from that will have to be converted into rupees.

Now if the exchange rate goes from $1 = ₹74 to $1 = ₹73, you stand to lose money. Hedging, your Forex returns by entering in a futures contract can help you mitigate some portion of this risk.

Conclusion

Some risks can be avoided, some can be minimized and others can’t be avoided. So how do you balance these risks?

It all depends on your risk appetite. You should create your portfolio after carefully analyzing each of the above risks and their consequences.

Also, you would need to continuously assess the current economic and political climate and identify any trends that may show up. Therefore, you need to keep yourself updated with all the events around you.

The better your analysis, the better will you be able to manage your investment risks.