Sep 27, 2013,16.06 IST
Seven major risks every investor needs to know
Investing your money and dealing with the associated risks is a great challenge that every investor must accept in order to reap higher returns.
Market investments are subject to risk (though the intensity differs from product to product).
Business supplements and magazines generally print the stories of hapless investors who either lost their money in shares, bonds or mutual funds or whose fund is stuck in the fraudulent moneymaking schemes. It is important for investors to identify the risk and take essential steps to minimize it.
In order to key out and minimize the risks it is vital to know the type of risks applicable to investments. For better understanding, here is the list of different investment risk types. Take a glance:
Market Risk – This risk is associated with the movement in the prices of stock that commonly affects the market as a whole. There are many factors that cause market fluctuation, and natural calamity is one of them. Other factors are the phase of the market – bull or bear.
The rising and falling prices of the stocks and bonds determine profit and loss of the investors. If the market is in its bear phase, the downside risk is comparatively low and on the contrary if it is in bull phase the downside risk is more as the market can crash anytime.
Socio Political Risk – Change in government policy, political unrest, international issues (war), elections and change of the government are some of the important elements that affect the market stability. This instability may impose a huge risk on your money/investment.
Liquidity Risk – According to a well-known fact, money has bounded or no value if it is not available when you need it. The ready availability of money is known as liquidity.
A successful investment is one that is not only profitable, but also readily liquid. For instance: If you have cash, you can buy anything anytime. But if you have an asset, which cannot be sold in the market due to a justified reason, it is of no use.
Remember, an asset is of a great value only if it can be converted into cash quickly, with little loss. It is good to invest in assets that are reasonably liquid. Otherwise your investment is at a huge risk.
Business Risk – The market value of your shares depends upon the performance of that stock in the market. If you have invested in the company that unfortunately isn’t doing well, the market value of that investment will rapidly go down.
When you invest in any company or enterprise, there are chances you may suffer loss or face bankruptcy. The risk associated with such investments may be little or in some cases very high. One common way to avoid such risks is to create a diversified portfolio.
Default Risk – The father of all, this risk refers to non-payment of interest and principal amount. This risk is particularly very high because of the investment in unsecured product, therefore no security is attached. In this case you can do nothing but end up filing a court case. It is good to refer the credit rating of a company before investing in it rather than regretting later.
Interest Rate Risk – Fluctuation in interest rate affects the fixed-rate securities and largely affects the value and returns of your investment. Whenever investors are buying a fixed-rate debt instrument they are exposing themselves to interest rate risk. For better understanding, listed below is an example.
If you have invested in a fixed-rate instrument for 5 years with the interest rate of 9 percent annually, and if the interest rate goes up to 10 percent the value of your security won’t go up. Because of the lower yield of the earlier instrument, the value of security comes down and trades at a discount in the market.
Therefore, interest rate fluctuations impose huge risk on the investor.
Exchange Rate Risk – It arises due to the change in the price of one currency against another. These risks are mainly faced by companies that have exposure abroad or involved in international dealings. Currently, India is under huge exchange rate risk.
How to Handle Risks?
When it comes to tackling the investment risks, it is important to make note of two things:
1. Not all risks may be applied to a single investment product
2. At times different types of risks are interlinked.
Gold carries exchange rate risk, government bonds are default risk-free but the returns are low, real estate carries highest liquidity risk therefore decent returns can be expected.
The presence of all these risks should not demotivate you from investing. Also, the presence of risk does not mean an investment is bad. In fact, investments with higher risk generally fetch good returns. No risk, no returns!
The author is Ramalingam K, CFP CM is the Chief Financial Planner at holisticinvestment.in, a leading Financial Planning and Wealth Management company.
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