Apr 02, 2012 05:52 PM IST | Source: Moneycontrol.com

Understanding the different types of risks

Considering the post 2008 market scenario, if there's one thing almost every investor knows, it's that there's no such thing as a free lunch. If you want gains from the markets, you're going to have to stomach volatility.

Understanding the different types of risks

~Risk is uncertainty, and in uncertainty lies opportunity~
 Lorayne Fiorillo

Considering the post 2008 market scenario, if there's one thing almost every investor knows, it's that there's no such thing as a free lunch. If you want gains from the markets, you're going to have to stomach volatility - and looking at the way things have been going since 2008, this is ongoing volatility.

But, in the wild ride we've all been on in the past 3 years, there have been some fantastic opportunities to grow your wealth. And people who have conditioned themselves to stay strong (read: unemotional) in their investing habits, have made a lot of money, despite the risks. This is the kind of investing behavior that will help you achieve your life goals through both equity and debt investments.

Today, with interest rates at their peak, debt i.e. fixed income investments are also a great place to be investing, depending on your goal time horizon and risk appetite. With equity markets experiencing volatility, valuations can be attractive too. Hence both equity and debt are strong potential investment avenues currently. With both asset classes available for sound investment, its best to educate yourself about the risks and rewards before you go ahead and invest.

To start with, let's go over the basics and see what the different types of risks are. Then we'll talk a little bit about the risk-reward trade-off, and summarize with the one investing rule that will never fail to help you make money and achieve your goals.

So, what are the different types of investment risk?

The 2 broad types of risk are systematic and unsystematic.

Systematic risk is risk within the entire system. This is the kind of risk that applies to an entire market, or market segment. All investments are affected by this risk, for example risk of a government collapse, risk of war or inflation, or risk such as that of the 2008 credit crisis. It is virtually impossible to protect your portfolio against this risk. It cannot be completely diversified away. It is also known as un-diversifiable risk or market risk.

Unsystematic risk is also known as residual risk, specific risk or diversifiable risk. It is unique to a company or a particular industry. For example strikes, lawsuits and such events that are specific to a company, and can to an extent be diversified away by other investments in your portfolio are unsystematic risk.

Within these two types, there are certain specific types of risk, which every investor must know.

1. Credit Risk (also known as Default Risk)

Credit risk is just the risk that the person you have given credit to, i.e. the company or individual, will be unable to pay you interest, or pay back your principal, on its debt obligations.

If you are investing in Infrastructure Bonds or Company Fixed Deposits right now, you should be aware of the credit / default risk involved.
Government bonds have the lowest credit risk (but it is not zero - think of Portugal, Ireland or Spain right now), while low rated corporate deposits (junk bonds) have high credit risk. Before investing in a bond or a corporate deposit, be sure to check how highly it is rated by a well known rating agency such as CRISIL, ICRA or CARE.

Remember, even a bank FD has some credit risk, as only a maximum of Rs. 1 lakh is guaranteed by the Government.

2. Country Risk

When a country cannot keep to its debt obligations and it defaults, all of its stocks, mutual funds, bonds and other financial investment instruments are affected, as are the countries it has financial relations with. If a country has a severe fiscal deficit, it is considered more likely to be risky than a country with a low fiscal deficit, ceteris paribus.
Emerging economies are considered to be more risky than developed nations.

3. Political Risk

This is also higher in emerging economies. It is the risk that a country's government will suddenly change its policies. For example, today with the continuing raging debate on FDI in retail, India's policies will not be looking very attractive to foreign investors, and stock prices are negatively affected.

4. Reinvestment Risk

This is the risk that you lock into a high yielding fixed deposit or corporate deposit at the highest available rate (currently above 9.50%), and when your interest payments come in, there is no equivalent high interest rate investment avenue available for you to reinvest these interest proceeds (for example if your interest is paid out after 1 year and the prevailing interest rate is 8% at that time).

Currently as we are at an interest rate peak, it would be advisable to lock in for a longer tenor (provided your financial goal time horizon permits) to avoid facing reinvestment risk.

5. Interest Rate Risk

A golden rule in debt investing is this: Interest Rates go up, prices of bonds go down. And vice versa. So for example in our situation today, we appear to be at an interest rate peak. This means that since interest rates are going to go down from here, prices of bonds are going to go up. So if you were to invest in debt funds now, you would be buying at a low, and can sit back and watch as your investments start to give gains as interest rates fall.

6. Foreign Exchange Risk

Forex risk applies to any financial instruments that are denoted in a currency other than your own. For example, if a UK firm has invested in India, and the Indian investment does well in rupee terms, the UK firm might still lose money because the Rupee has depreciated against the Pound, so when the firm decides to pull out its investment on maturity, it gets fewer pounds on redemption.
With the recent very sharp fall in the rupee, the forex risk of our country as an investment destination has greatly increased.

7. Inflationary Risk

Inflationary risk, or simply, inflation risk, is when the real return on your investment is reduced due to inflation eroding the purchasing power of your funds by the time they mature.
For example, if you were to invest in a fixed deposit today and you were to earn a 10% interest on it in 1 year's time, then if inflation has been 8% in that year, your real rate of return comes down to 2%, keeping purchasing power in mind.

8. Market Risk

This is the risk that the value of your investment will fall due to market risk factors, which include equity risk (risk of stock market prices or volatility changing), interest rate risk (risk of interest rate fluctuations), currency risk (risk of currency fluctuations) and commodity risk (risk of fluctuations in commodity prices).
There are other types of risk too, such as legislative risk, global risk, timing risk and more, but for the scope of this article, the ones explained above are the main ones you need to keep in mind, both on a macro (country) and a micro (individual investments) level.

-  PersonalFN is a Mumbai-based personal finance website


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