Investments and risks go hand in hand. Even the best investment options aren’t without risks. Without understanding investment risk, you cannot plan financially. Lots of people turn their back on investments due to the risks involved. The word 'risk' automatically brings the thought of being defrauded or not getting all of the money back. However, this is just 'capital risk’. But it is important to know that this isn't the only type. The risk of uncertainty and unpredictability lurk upon investments making it extremely difficult to say with certainty what the returns will be. However, predictions can be made. Several factors like share prices fluctuation, varying interest rates and inflation are risks too.
Once you understand the different types of risks, tackling them becomes easier. The secret, in other words, is to take calculated risks, not reckless risks.
Different types of investments and the risks involved
The several types of investment can be categorized into four main asset classes:
This is the least risky of the four. But it usually delivers low returns. So the value of your money can be eroded during times of inflation.
Government bonds or gilts, are riskier than cash, followed by investment grade corporate bonds, where you lend money to large companies in exchange for a fixed-rate of interest.
Commercial properties such as offices, supermarkets and warehouses, are alternate income channels through rental income and growth in the value of the property.
Shares or equities are seen as the most risky asset class, because of the volatile nature of stock markets. The risk factor is also determined by the kind of market you’re operating in. The more stable the market the lesser the risk as compared to emerging markets like India, China or Brazil.
Risks in different types of investment
Business risk in different types of investment
The value of your investment in shares is directly dependent on the company’s performance, in which you’ve invested. So its obvious that if the company performs poorly, the value of your shares suffers.
Some companies hit the IPO market with issues at high premiums, when the economy is strong and the stock markets are aggressive. But they lag on promises and the share prices are badly hit.
Default risk in different types of investment
This risk can be the most frightening of all investment risks. The risk of non-payment refers to both the principal and the interest. For all unsecured loans, e.g. loans based on promissory notes, company deposits, etc., this risk is very high. There is no security attached to it so incase of non-payment you can only fight it in a court, which is a futile exercise to begin with.
Look at the CRISIL / ICRA credit ratings for the company before you invest in company deposits or debentures.
Liquidity risk in different types of investment
What’s the value of money if it’s not available when you need it. In finance, the ready availability of money is called liquidity. So while you’ve learnt that your investment should be safe and profitable, here’s the third lesson – it should also be liquid. An asset or investment is said to be liquid if it can be converted into cash quickly, and with little loss in value.
Liquidity risk is the possibility that the investor might not be able to realize the value of the investment when required. This may happen because:
The security cannot be sold in the market
The security is prematurely terminated, or
The resultant loss in value may be unrealistically high
Certain banks offer loan schemes against security of approved investments, like selected company shares, debentures, National Savings Certificates, Units, etc. to add to the liquidity of investments.
It’s important to know that all listed shares and debentures are not equally liquid assets. Out of the listed stocks, active trading happens only on a few stocks. A-group shares are more liquid than B-group shares.
Purchasing power risk, or inflation risk in different types of investment
When prices of commodities shoot up, the purchasing power of your money goes down. This in simple terms is inflation.
Ironically, fixed income investments, like bank deposits and small savings instruments that are generally considered safe, are more prone to consequences of inflation risk. This is because rising prices corrode the purchasing power of your capital. Investments that’s are considered riskier such as equity shares are more likely to preserve the value of your capital over the medium term.
Interest rate risk in different types of investment
In this time of deregulation, the rates of interest keep fluctuating and this impacts investment values and yields. The interest rate risk disturbs fixed income securities, and refers to the risk of a change in the value of your investment as a result of movement in interest rates.
Political risk in different types of investment
The government’s power in affecting the economy is extraordinary. If it introduces legislation affecting some industries or companies in which you’re invested it can affect your earnings. Or it might introduce legislation granting debt-relief to certain sections of society, fixing ceilings of property, etc.
The old government and the newly elected one can operate on opposite political and economic ideologies. In the process, the fortunes of many industries and companies undergo a drastic change.
International political developments also have an impact on the domestic scene, what with markets becoming globalized. Due to increase in world trade, India is likely to become much more prone to political events in its trading partner-countries.
Market risk in different types of investment
This refers to the disturbance in security prices due to factors that affect the whole market. Natural disasters is an example of such factor. It’s important to note here that stock markets and bond markets are affected by rising and falling prices due to alternating bullish and bearish periods.
Bearish stock markets usually come prior to economic recessions
Bearish bond markets are generally come from high market interest rates, which are subsequently pushed by high rates of inflation
Bullish stock markets are witnessed during economic recovery and boom periods
Bullish bond markets result from low interest rates and low rates of inflation
Every investment opportunity comes with risks. Only the factors and degrees of risk vary. A thorough understanding of the risks is important for taking calculated risks and making reasonable investment decisions.