In the following article, some key points, definitions and explanations of the prominent risks involved while investing have been explained. To know more about the common risks, read on.
Do you know what actuaries of insurance companies and underwriters of leading corporations and financial institutions do? They mathematically try to ascertain the ‘risk’ associated with a certain insurance policy or an underwriter tries to ascertain the risk associated with a certain number of securities or a loan. In case of insurance policies, there is a probability that a person will face risk and make claim. For example, a sports car has a higher probability of risk of ending up in an accident, and there are higher chances of claims, and hence a higher premium.
Similar is the case when you invest money in sources such as mutual funds, variable annuities, shares, stocks and securities. Some prominent Systemic Investment Plans (SIP) and Collective Investment Schemes (CIS) also tend to have an element of risk embedded in them. In such investments, which are directly associated with the stock markets and investment destinations, it is not possible to bring about a specified mathematical figure to depict the risk.
Conditions and probabilities or possibilities associated with the risk are simply too diverse and infinite. These risks can however be classified into several categories and classes. Financial Industry Regulatory Authority (FINRA) of the United States has indicated two important and superseding types of investment risks, namely, systematic risks and non-systematic risks. There are some secondary classes such as ‘investing (read as verb or the actual executed action)’ related risks and assessing risks.
In the following paragraphs, we shall be concentrating only on systematic risks and non-systematic risks, which are quite commonly observed, though there are some uncommon and very scarce risks which are also involved. An important point that needs to be noted is that ‘a risk’ is chiefly a possibility or probability or rather a chance that in the future you may incur a loss with respect to your investment.
A systematic risk is the one which is associated with the markets and the general economy. A systemic risk is sometimes also known as a market risk. In such a kind of risk, there is a possibility and probability that the profitability or net worth of a said investment (say a 200 blue chip shares), is affected in a negative manner as a result of domestic and international economic and security and money market related changes. There are 6 prominent sub-categories of the systematic risks.
Interest Rate Risk
Interest rates are determined in accordance with the performance of the economy and the company or investment destination where you have invested. For example, if you have invested into the stock of a specified company then the annual dividend becomes the interest rate. Here risk is that there is a possibility that due to the poor performance of the company the inward cash flow and profits for the year have been affected and as a result, the company would not be issuing any dividend.
The effect is that current stock price of the shares is drastically affected, and the drop affects not only affects your personal balance sheet, but you cannot sell off the stock at a good profit and yield. Thus you are stuck with a bad priced stock.
The element of inflation and continual price rise is an inevitable element in all economies. Inflation as a risk is based upon the investor’s psychology and the general price levels. For example, 10 years ago I, invested $10,000 into a systematic investment plan and I got the returns today. Problem is, in 10 years the general price level has gone up so drastically that the value of the returns is not much. In some cases the returns may be negligible.
In case of inflation and interest related risks, the worst affected investments are securities (bond and debentures) and stocks, in some cases money market investments also play a key role. When general price levels rise and interest rates drop, the securities and instruments that we hold currently lose value. In such a case, new securities when issued have better interest rates and hence the value of all prior securities falls, leaving you with low priced securities.
In the modern world, mutual funds, systematic investment plans, annuities and other such investment ‘vehicles’, often tend to invest into Forex and foreign currency, off shore production processes, high yield off shore funds and in general, in several destinations where some foreign currency comes into the picture. In such cases, international events often tend to effect the currency value of our nation.
For example, an investment into Indian INRs (Indian currency), is rated to be $1 = INR 50 today, then after a few months it may drop down to INR 45 for every Dollar which is basically a loss, or a rather a risk of loss. Such a risk is known as a currency risk. Now it must be noted that the value of the Dollar may also climb to an exchange rate of say INR 52 for every Dollar.
Now, what is a successful investment? It is the one where you pay an amount to invest and liquidate or sell off the investment at a higher value, making profit. All market related conditions, economic events and conditions and also the aforementioned risks result into situation where the liquidity value or the current market value or the selling price is lesser than the total amount that you invested. Here you will face the risk of loss.
Unpredictable events, such as natural disasters, terrorist attacks, wars, frauds and other such countless events influence market and economies world wide. Thus in case of any such incidences, you will find that investments and securities are threatened by falling prices in the market. Result is loss of net asset value, a liquidity risk and another risk of facing after effects of the event such as inflation or hyperinflation or recession in some cases.
There are countless solutions to such risks, hedge funds, deposits and funds, alternative investments and even simply being alert or patient till the price rises and goes beyond the break even point.
The non-systematic risks are quite unpredictable and are also not usually related the general economy and the business environment. Non-systemic risks can consist of the following:
Management risk is the risk where the management of specified company, fund or the destination where you have invested your funds, take a wrong decision that may result into loss. Potentially you can suffer from things such as loss of share value or the net asset value. This kind of risk is prevalent for security investments such as stock and bond investments. Mutual funds and annuities rarely suffer from such risks.
Credit Related Risk
The credit related risk is the probability that your bond or instrument is defaulted and not repaid in full. Such risks usually arise due to very bad economic conditions, but they can be faced for any investment destination.
Understanding the risk and the possibility of the loss the comes along with it is of crucial importance. Hence when you make a standard analysis of a certain investment, take a look at the entire picture of the investment channel or destination.