Risk assessment forms an integral part of the entire financial planning process as it helps individuals understand and monitor risks that could impact their investments negatively and thereby its returns and goals dependent on them. This would help him carve out an appropriate investment strategy that would align with the time horizon of his goals and risk-taking appetite.
Think of it as - when you’re driving a car to a far destination, it's important to be aware of potential risks such as road conditions, traffic, roadblocks, and weather which could impact your driving experience and the timing of you reaching your destination.
After identifying these risks, you would ascertain the probability of each risk playing out. If there is a higher probability of heavy rains which could cause water logging on low-lying roads, you may alter your route or choose a different mode of transport. You will be working around all these external factors or variables while determining how to reach comfortably and in a timely manner to your location.
Investing also works similarly. There are various types of risks that could impact your investment portfolio returns. Different types of risks affect different types of asset classes and instruments, identifying them early and monitoring them closely can help you create a suitable investment strategy to navigate all types of risks.
We all know market risk can impact your portfolio returns negatively. However, nobody in the history of investing has been able to time the market perfectly. Staggering your investments and/or investing in strategies that take advantage of market volatility could help you stay on the path of compounding.
Inflation risk is a double whammy that affects your expenses as well as your savings negatively. Your lifestyle expenses go up on one hand and on the other, investment returns that do not beat inflation can negatively affect your purchasing power in future. Therefore, it’s important to invest in instruments and asset classes that give positive real returns. Gold has often been used as a hedging tool against inflation.
Liquidity risk in financial planning refers to the risk that an investor may not be able to sell their investments quickly enough to meet their needs or obligations. This can be a problem if you have unexpected expenses or if you need to cash out your investments quickly.
Liquidity risk is higher in case of physical assets like real estate or financial investments where there is a lock-in period. An appropriate mix of liquid and non-liquid investments, having a contingency fund, doing your cash flow planning can help you mitigate this risk in your investment journey.
Interest rate risk, credit risk and reinvestment risk is something that is spoken of closely in relation to debt instruments. The interest rate is one of the primary drivers of a bond’s price as it has an inverse relationship with it. In other words, when the interest rate increases, the price of a bond decreases. Long-term bonds imply a higher probability of interest rate changes and therefore, carry a higher interest rate risk.
When you invest in debt securities, there is always a chance that the issuer may not be able to service the interest and principal payments due to financial difficulties, economic downturns, or other reasons. This is called credit risk.
Investors may assess credit risk of an instrument by looking at the issuer’s credit rating, financial statements, evaluating the debt instrument covenants and other market related factors that may affect one’s ability to repay the debt.
Exchange rate risk affects your offshore investments. It refers to the possibility that the value of the foreign currency in which an investment is denominated will decline, resulting in losses when the investment is converted back into the investor's home currency.
In conclusion, evaluating risks is a continuous process, which could be a leading indicator of how to create your investment portfolio plan.
Donald D’souza is the Managing Director – Co-Head Investment Banking at Equirus Capital Pvt Ltd