Definition of Investment Risk
When investors invest their money in different types of securities or investment options, they expect a certain percentage of return on their investments. But as it happens, there is always the possibility of gain and risk of loss on the fund invested. The risk of occurrence of loss on the investment, or return less than the expectation is termed as investment risk. Sometimes investors lose their entire money if investment risk is not managed effectively.
The investment risk is associated with each type of investment, though the degree of risk differs accordingly. For example, investment in fixed interest bonds or debentures carry very low while risk associated with an investment in securities, shares, stocks, options are relatively higher. Investors invest according to their risk appetite or unique risk profile. Higher the risk appetite to take investment risks higher the expected rate of return by the investors.
Investors generally need to have an understanding of basic investment risk before investing. They also need to know how different kinds of risks can be applied to different kinds of investment scenarios. This will help them in managing the investment risk with a holistic point of view and will help in avoiding major and unnecessary losses.
Example of Investment Risk
Let us take an example where a person invests in an investment option and expects a yearly interest of a certain percentage every year. He intends to purchase an asset with the investment money after 10 years and contributes yearly into the investment fund for the same.
After performing all the calculation expects to receive $100,000 after 10 years and will be able to comfortably pay for the asset after 10 years. The expected value of the asset after 10 years is $90,000. Now the inflation rate is 4%. So after applying the inflation rate on expected value, the actual value would be $133,222, while the return from the investment would just be $100,000. This is an example of inflation risk.
Types of Investment Risk
The investment risk is further divided into two broader categories, systematic risk, and unsystematic risk. Systemic risk is market-related risk and it cannot be reduced or avoided through diversification of the portfolio. Unsystematic risk is a non-market-related risk and can be reduced to an extent by reducing the existing portfolio. Let us now look into further subcategories of investment risks under systematic and unsystematic investment risk.
1. Systematic Risk
- Inflation Risk: The risk of reduction in the actual worth of the investment and its return due to inflation. This type of risk majorly impacts fixed income interest securities as inflation or purchasing power risk can erode the real worth of the investments.
- Reinvestment Rate: the risk of reinvestment of investment proceeds at a lower rate than the original investment which generated the proceeds. Long term investments, stock, and zero-coupon bonds are the most impacted type of investments under this risk category.
- Change in Interest Rate: Any change in interest rates due to market forces or regulatory laws will impact the return of the investments.
- Exchange Rate Risk: The risk associating with fluctuation in the value of the current of the investment, due to which the actual worth of the investment is reduced. This mostly impacts the investment of foreign companies.
2. Unsystematic Risk
- Business Risk: The impact on the return of the investment due to the fluctuation in the businesses’ or company’s operating income is termed as a business risk.
- Financial Risk: The risk of a lower rate of return due to a change in the financial structure of the company is termed as a financial risk for example company that is unable to meet its liabilities won’t be able to pay dividends or interest.
- Political Risk: Political risk includes change in legislation, laws, trade barriers, etc that could negatively impact the expected rate of return on the investment.
- Liquidity Risk: The risk associated with not being able to convert the investment into ready cash at the time of need or not being able to find the buyer in the market is termed as liquidity or marketability risk.
- Investment Manager Risk: The risk associated with the inability of the investment manager to manage the risk effectively is termed as investment manager risk.
Investment Risk Management
Investment risk management comprises of below steps:
- In the first step, all the risk relating to the investment portfolio needs to be identified and noted down. The investment managers should ensure to cover different types of risks the investment is exposed to including systematic as well as unsystematic risks.
- In the next step, the investment managers should look into the analysis of the risk part; they should define the scope of the investment risk and consider all the factors that can impact the scope of the risk.
- In this step, different types of investment risk associating with the portfolio should be ranked accordingly. The risk that would highly impact the return should be ranked highest and so on. This will help management to focus on a higher rating risk that could result in major losses.
- In this step, the actual managing of the risk already defined in previous steps is taken care of by deploying various management strategies and would be solutions. In other words, in this step, the investment managers work towards eliminating or at least containing the risk.
- There are some investment risks that cannot be eliminated or uprooted, these risks need to be monitored and reviewed from time to time to check the intensity of their impact on the return.
The disadvantages of investment risk are as follows:
- Managing investment risk comprises of complex calculations and is a very time-consuming process.
- If the investment manager is unable to manage risk effectively, the company will have to bear losses.
- Some investment risks are depended upon external factors that are not easy to manage.
- It involved huge investment from the company’s side thus increased cost.
- The accurate determination of investment risk depends upon a variety of factors including the strength of the model, the validity of assumptions, and the quality of data.
From the above discussion, it is clear that investment risk cannot be completely separated from the investment, but they can be managed, contained, and reduced. There are different types of investment risk falling under the broad category of systematic and unsystematic risk. The investment managers managing the risk need to be highly skilled and should have a solid understanding to better manage the investment risk.
This is a guide to Investment Risk. Here we also discuss the introduction and Types of Investment Risk along with Example and disadvantages. You may also have a look at the following articles to learn more –