Savings becomes investment only because of risk. Risk is an inherent part of any investment activity. Some of the risks associated with an investment are:
- Loss of capital.
- Delay in repayment of capital.
- Non-payment of interest.
- Variability of returns.
Different investment products have various risks.
Government securities and bank fixed deposits have a high safety and thus negligible risk. Shares, on the other hand, have an increased risk. It can give profit and, at the same time, has the potential to erode the capital to almost zero. Risk and return are directly related.
The higher the risk taken, the higher could be the return. Similarly, the low return comes with low risk.
Terminology in Risk Measurement
Variance is the mean of the squares of deviations of individual returns around their average value.
Standard Deviation is the square root of variance.
Beta measures the volatility of an investment return about the market return.
All investments involve some degree of risk.
Risk refers to uncertainty and potential financial loss inherent in an investment decision. In general, as investment risks rise, investors seek higher returns to compensate themselves for taking such risks.
Every saving and investment product has different risks and returns. Differences include: how readily investors can get their money when they need it, how fast their money will grow, and how safe their money will be.
Types of Risks that Investors Face
Business Risk
With a stock, you purchase a piece of ownership in a company. With a bond, you loan money to a company. Returns from both of these investments require that the company stays in business. If a company goes bankrupt and its assets are liquidated, common stockholders are the last in line to share in the proceeds. If there are assets, the company’s bondholders would be paid first, then holders of preferred stock. If you are a common stockholder, you get whatever is left, which may be nothing.
Credit Risk
The risk is that the government entity or company that issued the bond will face financial difficulties and be unable to pay the interest or repay the principal at maturity. Credit risk applies to debt investments such as bonds. Credit risk is similar to business risk.
Volatility Risk
Even when companies aren’t in danger of failing, their stock price may fluctuate up or down. Market fluctuations can be scary to some investors. In addition, a stock’s price can be affected by factors inside the company, such as a faulty product or by events the company has no control over, such as political or market events.
Inflation Risk
Inflation is a general upward movement of prices. Inflation reduces purchasing power, a risk for investors receiving a fixed interest rate. The principal concern for individuals investing in cash equivalents is that inflation will erode returns.
Interest Rate Risk
Interest rate changes can affect a bond’s value. The investor will receive the face value plus interest if bonds are held to maturity. The bond may be worth more or less than the face value if sold before maturity. Rising interest rates will make newly issued bonds more appealing to investors because the newer bonds will have a higher interest rate than older ones. To sell a more senior bond with a lower interest rate, you might have to sell it at a discount.
Liquidity Risk
This refers to the risk that investors won’t find a market for their securities, potentially preventing them from buying or selling when they want. This can be the case with the more complicated investment products. It may also be the case with products that charge a penalty for early withdrawal or liquidation, such as a certificate of deposit.
Conclusion: Investments are with risks; Investors should factor them
Risk is the probability of losing something of value. Investment risk is the probability of losing part or all of the original value of an investment. There are various investment risks, including market risk, credit risk, inflation risk, and liquidity risk. Market risk refers to the decrease in the value of an investment due to interest rate fluctuations or exchange rates that may impact the investment. Bonds or mutual funds are more subject to credit risk or interest rate risk, and liquidity risk is the potential to lose investment value due to the inability to convert the investment quickly into cash.
All these investment risks could be difficult to ascertain by an individual investor. Often, these risks prevail in different investment products, and investors cannot identify and manage them. Therefore, investing in high-grade investment products, whether equity or debt securities, is advised. If not comfortable, screen them in managed funds like Mutual Funds and ETFs with consistent performance over a more extended period and a high-performance rating.
