Home » News » Personal Finance»Fixed Income - Bonds
Apr 02, 2012, 05.52 PM | 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.

 PersonalFN
~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

 

ADS BY GOOGLE

Ask the Experts

Get your Personal Finance queries answered

  • Q

    If I put Rs 2 lakh in PPF, how much tax rebate I will get?

    A

    As per the existing guidelines and rules a person cannot deposit more than 1.5 lacs in one PPF account. However you can deposit money in the...

  • Q

    Interest rates are going to go down. And all my fixed deposits will be maturing next year. I will have to renew my fixed deposits next year at lower rate of interest. What is the way out?

    A

    Interest rates keep fluctuating due to various micro- and macro- economic factors. There is never an ideal rate of interest. In a high inter...

  • Q

    I want to buy online term life insuance plan. Which is the best one? Should I go for single premium or regular premium policy?

    A

    Single premium term insurance policies don?t make much sense. Why pay such a large amount at one go when you have the option of paying in sm...

  • Q

    I want to invest some money with at least ten years view. I dont want share market risk. Can I invest in NSC? Is there any other investment option?

    A

    NSC or National Savings Certificate is a safe investment scheme offered by the Central Government. It is an ideal option for investors with ...

  • Q

    Is it a good idea to invest in asset allocation funds? if yes, please suggest some good fund to invest money. I am 35 years old and can invest Rs 10000 per month.

    A

    Asset Allocation Funds are for those investors who want to take an exposure into different asset classes but do not wish to create their own...

  • Q

    My CA says that I have to pay tax on interest accrued on my FD of Rs 20 lakh. I have submitted form 15H in all banks. Is it necessary to pay tax in this case?

    A

    In case of interest on fixed deposits which is taxable under the head ?Income from other Sources? a taxpayer has two choices. Either you can...

  • Q

    Please suggest a good investment option of land in South India. I want to buy a land parcel of around 2 acres.

    A

    If you take a look at the South Indian real estate market, Bangalore has emerged as a clear winner. Due to the strong presence of IT/ITeS an...

  • Q

    I want to invest Rs 20000 per month. I have identified Reliance Small Cap Fund and DSPBR Micro cap fund for investment. I can hold to investments for two years. Is it a good idea to invest in these schemes? How much returns I will be getting?

    A

    If you are an aggressive investor, you can consider investing in either of the 2 funds.DSPBR Micro Cap My suggestion is that if you are inve...

  • Q

    I want to save my money for retirment Please suggest a good insurance policy

    A

    For retirement it is advisable to use multiple investment instruments and not just life insurance policies. If you have 15 years or so for r...

  • Q

    IS IT a Good time to invest in GOLD ?

    A

    Currently the outlook for gold is bearish/negative. However if you are planning for a long-term investment in gold it is ideal to invest the...

  • Q

    I have retired from my job in November. I have got Rs 48 lakh from my employers, by way of epf, gratuity and other benefits. Should i invest in senior citizen scheme of LIC? How about pension plans from LIC?

    A

    1. You can invest Post office Senior Citizen Scheme. 2. You also should invest lumpsome in MIP in post office and get monthly interest. 3. K...

  • Q

    I want to save Rs 1 crore for my retirement when i turn 60. Now I am 42 years old and have fixed deposits worth Rs 18 lakh.What should I do to reach Rs 1 cr mark?

    A

    start investing a minimum 5000 per month in mutual fund and increase 10% to 20% every year....

  • Q

    I want to save on my utility bills and fuel expenses.Please suggest a good credit card for me.

    A

    Yes, you will be able to save on Utility bills and fuel expenses through the cash back schemes offered by some of the credit card companies....

  • Q

    Suggest couple of equity mutual funds for me. I am keen to invest Rs 25000 per month for next couple of years. I can remain invested for at least five years?

    A

    Asset Allocation Funds are for those investors who want to take an exposure into different asset classes but do not wish to create their own...

  • Q

    I am a senior citizen.I received interest of Rs .1,70,000/- on FD.I have duly filled 15G form.I have NO other source of income.Have I to pay Income tax on this interest or can it be excempted?

    A

    Sir, please note if you are less than 80 years but more than 60 years of age, your total income upto Rs 3,00,000 is exempt from tax, you are...

  • Q

    Please suggest a good money back policy for me. I am 27 years old and want to accumulate Rs 10lakh over 10 years.

    A

    If you are a fan of traditional money back policies, go in for the LIC New Money Back Policy of 20 or 25 years. I would suggest you go in fo...

  • Q

    I want to buy a life insurance for my brother Please suggest a good policy. He is 19 years old. he should get Rs 5 lakh when he turns 25 years.

    A

    Best to go in for a ULIP in case he is looking to grow the money also. Go in for a ULIP like HDFC Click 2 Invest which is very low on charge...

  • Q

    In 2013, I bought an Endowment policy from LIC. Premium for that is around 35K per year. Now i understand, this was a big mistake and i want to go for a term insurance policy. I have already paid two premiums in 2013 and 2014 and I want to make this policy paid-up. Can i pay one more premium this year and make that endowment policy paid-up ? Or is there any better alternative ? Please suggest.

    A

    Yes, you can convert to a paid-up policy after 3 years premiums have been paid. I would recommend that you surrender the plan and take back ...

  • Q

    Is zero depreciation cover a good option under auto insurance? I have plans to buy honda city in January

    A

    Zero depreciation is a good option to along with the standard car insurance plan. By paying a slightly increased premium you can ensure that...

  • Q

    I am 20 years old,I am getting 17+ % or returns from share in my portfolio consistently for the last 6 months.should i think about a career in stockbroking?

    A

    Its nice to note that your portfolio has been gaining such high returns, however it might be too early to take a call and make stockbroking ...

Explore Moneycontrol

Copyright © e-Eighteen.com Ltd. All rights reserved. Reproduction of news articles, photos, videos or any other content in whole or in part in any form or medium without express written permission of moneycontrol.com is prohibited.