Most of us have the tendency to equate risk with loss. As if every time we take risk we will lose. Equity investing is risky doesn’t mean that we will lose money if we invest in shares.

Risk does not mean loss. Risk is not bad. In fact, risk is good. It is an opportunity. It is a chance to earn better returns.

The real problem is not the risk but the ignorance of risk. If we invest like a gambler without understanding and managing risk, the probability of loss is much higher. On the contrary, if we learn to manage risk, we can considerably reduce the chances of losing money.

A.  The Credit Risk

Many of us would have been in a situation where the company/bank delayed paying the interest on our deposit with them or even worse, did not pay any interest at all. And to compound the problem, it didn’t even give back our original amount.

This is credit risk – the risk of not receiving the interest and/or the principal.

It is usually applicable to our fixed deposits with companies/banks, debentures, bonds or similar such instruments.

We can take certain precautions before investing, so as to minimize the credit risk. One would be to invest our money only with large, reputed and profitable companies, which are having a very good track record. Second, we should check the credit rating given by independent agencies like CRISIL, CARE etc. These give ratings such as AAA, AA, BB etc., which indicates the level of safety.

Needless to say that better the rating lower would be the interest. So one has to make ones’ own choice – higher safety lower return or lower safety higher return.

Check whether the interest rate being offered is much higher than what the company can legitimately earn? For example, the company may be able to earn 12-15% from its’ business, but is willing to pay 18-20% on the fixed deposits. Why would the company offer you more and incur a loss, unless its’ intention is not to pay you at all. So be very careful of the high interest rate hype.

B.  The Interest Rate risk
The Indian economy is more liberalized than say a decade ago. The Govt. is continually reducing its’ controls on a host of economic activities making them more and more market determined. Hence, it is the market forces and not the Govt., which will determine the interest rates.

Consequently, the volatility of interest rates is a risk, which has become a more common phenomenon.

Remember that, till a few years ago we used to invest in PPF at 12-12.5% interest rates. The Govt. has since then progressively reduced the interest rates on PPF and other similar products such as NSC, Post Office Schemes etc. to now around 8%. So, investing in Govt. schemes is also a risk, which we usually don’t realise or appreciate.

Or say we made a 5-year bank FD at 7% last year. The rates have meanwhile hardened and today one may get even 8-8.5% interest. Hence, by locking ourselves for 5 years, we have lost the opportunity to earn higher interest.  

Being aware of the general economic conditions would help us to take a more informed decision. Today, the expectations are that the interest rates may rise. Therefore, one could wait before committing oneself to a long-duration FD. Meanwhile, one could invest in floating rate bonds.

Fixed deposits, bonds, debt mutual funds are some of the financial instruments susceptible to interest rate risk.  

C.  The Liquidity Risk

Keeping a lot of idle cash in a bank means we are loosing opportunity to earn higher returns thru’ investing.

Too low a cash balance can also be a problem. If we suddenly need some money, we would have to prematurely liquidate our investment. This, as we are all aware, has a cost. There is a penalty if we close our FD before the due date. Mutual funds charge an exit load if the investment is redeemed in less than 6 months/1 year. 

Or sometimes the investment cannot be easily converted to cash, even at a cost. For example one may not be able to prematurely close a company FD. Or say we have a scrip, which is very thinly traded and hence difficult to find a buyer.

Lack of a proper balance between cash & investments is what is generally called the liquidity risk (or the asset-liability mismatch). Sure, one can never maintain a perfect balance all the time. But one can definitely minimize the loss due to the liquidity risk.

We need to see what and when are our inflows like salary, rent, dividend etc. and match the same with our expenses/liabilities viz. day-to-day expenses, EMIs, school fees, etc. This will help us create a proper balance between inflows and outflows.

As a thumb rule, liquid money equivalent to 2-3 months’ of our normal expenses is likely to achieve a fair balance.

D.  The Market risk

When the value of the investment varies with the market conditions we have market risk. Shares is the best example of a financial instrument which is prone to market risk.

The prices of such instruments are generally quite volatile. Demand-supply gap, economy, corporate performance etc. play a significant role in their value determination. Therefore, such investment options can be a source of significant gains or losses.

Considering high volatility, such investment options require lot of research and a close monitoring.

Historically, it has been seen that regular investment of small amounts over a long period of time in shares has given good returns to an investor. Thus systematic long term investing could be one way of minimizing market risk. Second, we could take advantage of the professional expertise and diversification of a mutual fund to reduce risk. Third could be a disciplined approach to booking profits/losses.

Risk is inherent to money. Even keeping cash at home is risky. Inflation will erode its’ value over time and reduce the purchasing power. We shouldn’t be like an ostrich – just closing our eyes doesn’t mean that the risks will go away.

Instead (a) Be aware that every situation has a risk, (b) Understand the risk and its’ likely impact, (c) Match the risk profile of an investment option with your risk appetite and (d) Manage the risk proactively. The result would be quite fruitful and rewarding.

The author is an investment advisor. He can be reached at smatai@hotmail.com.