Types of Risks in investments and how to manage them
Does the word Risk haunts you or excites you? Do you consider risk as opportunity or uncertainty? Do you agree that even the so-called safe investments are risky? What is riskier – Investing or Not Investing? Which has more risk – Equity or Real estate? Is Financial Planning risky or the risk is in not doing planning at all?
Answers to the above questions depend on your understanding of the word RISK and types of risks. Generally, the word risk is taken same as Loss, but actually, it’s not so.
There are so many definitions of risks.
As per Wikipedia Risk is the potential of gaining or losing something of value. Values (such as physical health, social status, emotional well-being, or financial wealth) can be gained or lost when taking risk resulting from a given action or inaction, foreseen or unforeseen (planned or not planned). Risk can also be defined as the intentional interaction with uncertainty. Uncertainty is a potential, unpredictable, and uncontrollable outcome; risk is a consequence of action taken in spite of uncertainty
Everything around you has some sort of risk factor in it. The medicines you take may cure you or may give you some allergic reaction. The sport you play may injure you. The Car
you drive may break down.
You cannot avoid Risks, you either have to manage it or Transfer it. If no option of management or transfer is there then you have to accept it and prepare yourself for the consequences.
This leads me to give a broad breakup to the types of Risks – Known and Unknown Risks.
Known risks can be managed or accepted well, but unknown risks can result in anything unknown. In the words of Warren buffet, Risk comes from not knowing what you are doing. When you know what you are doing you are playing in the “Known risk” categories.
In this article, I will take you through some types of risks which are known risks and are present in the economy in general and in specific financial instruments, and some ignored risks which though known to everyone but gets ignored in financial management.
Types of Risks: Known Risks
Systemic risk and Un Systemic risk
They say financial markets are the reflection of the economy as a whole. If the economy is doing well then financial markets should also be performing well and Vice Versa.
Now, this also means, that anything specific happening in the economy (good or bad) is going to impact your overall investments as well (positively or negatively), and you can’t do anything about it. This is what Systemic risk is.
Systemic risk is something which impacts the whole economy, country, or a broader group and thus affects each and every constituent of the same. This is also called non-diversifiable risk.
Inflation Risk, Market Risk, Political Risk, Interest rate risk, are some of the examples of Systemic Risk.
Un Systemic Risk, on the contrary, are a types of risks which impacts a particular section of the group – company, Stock, security. Say for e.g. Government raising taxes on tobacco will impact ITC in a major way, but not Pharma, Steel, cement companies. Tata and Infosys group’s Internal issues will not impact any other company in their specific sector. This risk can be managed well with proper diversification.
Inflation Risk – Rise in general prices impacts every company, household and even governments for that matter. High inflation results in high expenditure and also higher cost of production. The higher cost of production has a spiralling effect and further increase the prices of the final output.
In growing economy, you cannot save yourself from the inflation risk. Moreover, a reasonable inflation rate is healthy for the economic growth. But Inflation risk can be managed well by diversifying your investments into instruments which have growth rate higher than the Inflation rates.
All businesses strive for high post inflation and post-tax growth, and Investing in business means investing into equity.
The government also wants to protect its citizens from inflation and thus offer a higher rate of interest on government-sponsored schemes, even corporates offer high rate than the inflation rate, but most of these instruments are taxable which sucks out the benefit of high rates.
Inflation is a slow poison. Its impact is not visible with naked eye but in retrospect only. We all know the cost of things 10 years earlier. Except mobile recharges I guess everything has risen only.
Market Risk – Market risk is a systemic risk which will impact each and every constituent of it. If market sentiments are weak, then all stocks even if under good management and stable and growing business will get affected.
Recall 2008, each and every company in the stock market fell, though good companies recovered faster. For short time it impacted even the debt segment of the market.
The best way to manage the Market risk is Asset Allocation.
Currency Risk – This types of risks is also called as Exchange rate risk. Just like stock markets, currency rates also get affected by many different factors. The movement in the currency rates may impact your investments if you have directly invested in the other country of your residence, just like NRIs do in India.
This will also impact on your domestic investments if the company you have invested in have international business and dealings.
In today’s kind of global economy, it is difficult to keep yourself safe from currency risk. However corporate houses do trade in currency derivatives to manage such risk to have the least impact on their balance sheets and your investments.
Political risk- Any country’s policy-making depends solely on the political stability and situation. The government at the centre will play its shots which may or may not be taken positively by market and citizens.
This is not only about the political scenario in your own country, but also where your investments are, where your business dealings and operations are.
Donald trump policies on the Immigrants and taxation will directly impact the NRIs working there and also the companies having operations there. Narendra Modi Policies are directly impacting Indians.
When you are not clear on the outcome there is the risk. So, accept the risk, and manage yourself within the risk.
Taxation risk- Inflation and taxes are considered to be two holes in the pocket. Both suck your money out of your system. High taxes directly impact your cash flow. High taxes mean low profitability of the companies you have invested in.
Though high taxes sometimes also mean improvement in governments fiscal front.
In personal finance, taxes can be managed with proper planning by taking advantage of available deductions and spreading of Income. Seek out for tax-efficient investment products like Mutual funds.
Interest rate Risks- Interest rate scenario is being managed by RBI in India, through its monetary policies. Inflation and growth are the 2 major concerns which drive the RBI decisions on Interest rates.
In the High inflationary scenario you will see interest rates going up, as RBI wants to control the supply of money to control inflation, and when the growth concerns are high then the interest rates generally are on downward trend.
Interest rates impact your loans, business cost of capital, inflation and thus you. But you can’t do anything about it. However, in investments especially in debt-oriented instruments, you can manage your returns by investing in different instruments of long and short duration to optimize the returns.
Credit Risk – Also known as default risk. This types of risks impact you when you have given a loan to someone or invested in debt instruments. Credit risk is the risk of not getting your capital back along with the timely interest payouts. It is the risk of the creditworthiness of the borrower.
At the financial investment level, you can manage this risk by investing in high credit rated bonds and structures, where chances of default are less.
Liquidity Risk – Liquidity generally signifies the quantum of cash flow in your profile or how easily your investments will be liquidated and in what time.
Banks lend you or your business looking at the liquidity position. Even if you have many properties in your name but do not have a regular and stable earning source, banks will be reluctant in lending you.
Your Expenses and goals will be met by paying money, not by just staying invested in some instruments even if they are growing. You need liquid money for your requirements.
Types of risks – Some unknown and Ignored risks
Health Risk – We know that in today’s kind of scenario, no one is immune to health problems. With age, we are prone to many illnesses. Also, due to our deteriorating lifestyle, we invite many diseases ourselves.
Making and multiplying money is fine, but all this will be washed out if health is not taken care of well. This is known to every one of us, but hardly anyone is working on it.
Health insurance can only manage the expenses and that too to a specific level, but it will not improve your deteriorated quality of life due to illness. So adequate health insurance cover is must but you also have to take good care of your health.
Life risk – Or I should call it a Death Risk? This can’t be managed, everyone has to die someday, but at least by understanding this, we can make such arrangement so our dependents should not suffer due to our mismanaged issues.
Buying life insurance with adequate cover, writing will, having proper nominations on financial documents, keeping most of the investments in liquid form are some ways we can provide them ease in managing our affairs after us.
Longevity risk – Though we are not sure with the improvement in medical facilities, somehow, we have increased our lifespan. There is a treatment available for all major illnesses. We may live long, but with deteriorating lifestyle, we are hitting the quality of life very badly.
It’s not only about health but money also. You can never be sure how much is enough. But you have to have the enough so your money should last longer than you. Budgeting, Investing, and moreover, proper financial Planning is a must.
Behaviour risk – We are a victim of our own behaviour, so our mood swings, behaviour biases, notions built on good and bad past experiences are a risk to our investments.
In search of safe instruments, we tend to get into illiquid low yielding insurance policies, we go overboard on particular asset class in the lure of gaining more and forget the diversification rules.
We think that whatever is happening currently or in the recent past is the only reality and future will go like this only, we believe that if everyone else is doing one thing then we should also do the same and feel secure in our decisions.
All this and much more are the reasons investors don’t make money even when investments are generating it.
The best way to manage the behaviour risk is to follow a process. Goal-based planning with automating investments and timely review with set structure will help.
The types of risks list as above are not exhaustive. As I said that there is some sort of risk in everything we do. These are just names given to understand the risks and how better we may be able to manage it.
Once you understand and accept the risk, you will figure out the way to manage it. Some ways are defined and already structured like Diversification, asset allocation and Financial planning, and some get innovated in the process.