All investment decisions we make come with risks.
The decision will relate to the amount of money we invest, our circumstances at the time, and our needs for the future.
But, what is risk? Well, risk is simply the possibility that we may not achieve our financial goals. Remember, risk and return go hand-in-hand i.e. higher the risk we are willing to accept when investing – higher could be the potential of generating better returns, and at the same time higher will be the potential of suffering superior losses.
So, what are the different types of investment risks?
Mismatch Risk
The investment we choose may not be suitable for our needs and circumstances. For example, we want to purchase a house on an outright basis after one year. However, most of our investments have been invested in National Saving Certificate (NSC) which is locked-in for six years.
So better than choosing any financial product it is very important to align it with your financial goal. First, decide your financial goal and its timeline then search for the suitable goal.
Inflation Risk
The real purchasing power of our money may not keep pace with inflation. Oof, too much jargon? Let's rephrase. A pack of chips cost ₹10 for 40 grams. Two years later, for the same price you get 36 grams, or, the 40 grams pack now costs ₹12. In effect, you are spending more money for the same product and quantity. That's inflation.
Inflation is a silent killer of your accumulated wealth as well your current investment amount. Always discount it in any calculation you do for the future goal corpus.
To defeat the inflation monster you need to invest in inflation hedged financial instruments like equity mutual funds for long-term goals as well as need to earn and invest more than required for the debt asset class products.
Reinvestment Risk
For investors relying on fixed-rate investments, we may have to reinvest the maturing amount at a significantly lower rate. This risk erodes our wealth slowly as the future return keeps on decreasing over a period of time. In the falling interest rate scenario, this risk keeps on increasing in the future.
The solution is following asset allocation strategy. Invest good amount in inflation-hedged financial instruments like equity mutual funds for long-term goals. For the debt asset class, try to invest for a long time with a higher interest rate if you do not need money urgently or over a couple of years time. For example, you can invest in Kisan Vikas Patra which matures after 10 years four months instead of National Saving certificate which is of five years.
Market Risk
Movements in stock market mean the value of our investment can go up or down. That is, you may earn or lose money. This risk is seen in market-related products. Such products can be very volatile in a shorter period of time. The more the risk involved more the volatility is seen in such a product.
Case in point, the global market fall over the past few weeks due to Russia-Ukraine War.
This risk can not be nullified completely in the market-related products, however, if you remain invested for a longer period in such product then such risk can be minimized and you can take a calculated risk for the inflation hedged return. The solution to minimizing this risk in the overall portfolio is to have a cushion of fixed income instruments and follow the right asset allocation all the time.
Market Timing Risk
Anticipating market rises and falls can be extremely difficult. One cannot time the market and this is a UNIVERSAL TRUTH. So do not waste time in TIMING the market and sit on the cash for a longer period of time.
When the market is in the bull-run we can not predict its peak either when the market is in a bear run we can not predict its bottom. So in the equity asset class, it is always preferable to invest in the staggered way in both bull and bear runs.
Risk of not Diversifying
If all of our investment is in a single asset class – irrespective of investment vehicles – and if that asset class does worse then all of our capital will be affected. It is a famous saying that “Don’t keep all your eggs in one basket”.
You have to diversify in different asset classes such as cash, equity, debt, gold, and real estate. Choose the asset class as per your financial goal’s need. Decide the percentage as per your risk-taking ability and have a good asset mix and make the all-time weather-perfect portfolio.
Liquidity Risk
We may not be able to access our money quickly or without cost in times of need. This is also underestimated risk for many investors. For the sake of tax saving most of the time, we invest in such products which are having mandatory long-term lock-in periods. In such a scenario our money is locked and it becomes illiquid for us. This risk is similar to the mismatch risk.
A better solution for this risk is always to invest the longer lock-in periods financial products only if your financial goal is a long-term goal. Choose PPF or NPS only for your retirement goal if it is more than 15 years away. Do not choose such products only for saving taxes.
Credit Risk
It applies to debt-type investments such as term deposits, debentures, and debt-oriented schemes. The institution we have invested with may not be able to make the required interest payments or repay our funds. This risk prevails when the bonds are of private issuers as well as of low quality and bonds are of a very long period.
So always invest in AAA-rated bonds only. Choose central government or RBI-issued bonds for your long-term bond investments. In debt mutual funds avoid credit risk bonds and long-term debt funds. I prefer to stick with liquid funds and ultra short-term debt funds for my debt fund portfolio.
Legislative Risk
Our investment strategies could be affected by changes in the current laws and regulations. The Government or regulator can change the policies anytime before any prior notice. We have to be ready for such risks while planning for our finances.
We can not do anything in this type of risk but adjust to the new rules and regulations quickly for being adhered to the rules laid down by the officials.
Gearing Risk
When we borrow to invest this can significantly affect the risk of our investment portfolio since we are leveraging a variable and un-assured cash inflow vis-à-vis an assured cash flow. Kindly understand the return on the money invested in the stock market or mutual funds is never certain. No one can ever predict the rate of return from the Equity asset class in short term as well as in the long term as the equity assets class is the riskiest and most volatile asset class.
On the other hand, the loan instalment starts from the very next month on the loan you have taken for this purpose. The EMI is fixed at the rate at which you have taken the loan as well as the tenure., It means the EMI amount and the time of monthly repayment are fixed.
Invest in the stock market or equity mutual funds only with the money you earn. Not from any bank, not from your parents, not from your relatives or friends.
This article was first published here.
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Preeti Zende is a SEBI registered Investment Adviser and Fee only financial Planner. She is Founder and owner of Apana Dhan Financial Services, Associate of Insurance Institute of India.