Understanding Investment Risk

What is the basic reason that one investment will pay a greater return than another? Well, there could be many reasons, but believe it or not, the greatest overall determining factor is that of Risk!

Risk can be defined as the possibility that the actual return on an investment will be different from the expected return. Rational investors expect to receive a higher return for increased risk. Therefore, the higher the return from an asset, generally speaking, the higher the associated risk. Conversely, the lower the risk associated with an investment, the lower the rate of return from that investment.

Why consider risk?

There are two types of financial risk: The first is where there is some probability of a negative outcome that will have financial implications. This is usually a risk to property or person and is coverable to some extent by insurance. The second type of financial risk is associated with investment. This is where there is a risk of flat, low, no returns or a loss of capital. We will now look at the types of investment risk and your attitudes towards taking risks.

There are two specific reasons why you need to consider risk:

  1. To a large extent, all your investment considerations should be devoted to finding investments that offer the best combination of probable benefits and probable risks.
  2. You need to consider the maximum degree to which your invested capital should be exposed to risk, taking into consideration the time horizon of the investment and your return requirements.

Considering risk in most investment cases is imperative as there is no guarantee that a particular investment will perform to expectation or even to industry average. Furthermore, the very reasons that sometimes cause an investment to perform well in one set of economic circumstances can also cause it to perform poorly in another set.

What are the sources of investment risk?

The more obvious sources of risk that can be identified and researched include the following:

Business risk

Business risk is the risk that investment results may be disappointing or there could be loss of income or capital brought about by inefficient management, bad trading policies, lack of adequate long-range planning, changes affecting a particular industry, changing government legislation, business cycles, and so on. The uncertainty faced by an investor increases when there is an uncertainty about profit flows from the business.

Financial risk

Financial risk is the risk of loss, including partial or complete loss of invested capital in the event of the failure of a company or scheme resulting from an unsound financial structure. High amount of borrowed financing increases uncertainty of returns available to equity shareholders.

Market risk

Market risk is the risk of capital loss caused by the market cycles such as those experienced quite dramatically in the share market and to a lesser extent the property market. This definition could also be extended to cover systemic risk-the risk that losses may occur, due to the failure of the market system.

Interest Rate Risk

Another type of risk, which does affect securities such as government bonds, arises from interest rate fluctuation and is commonly termed interest rate risk. If you purchase a bond with a yield of 12 per cent and interest rates rise to 14 per cent, you will in effect suffer a capital loss. To illustrate, a bond with a face value of Rs.1,000,000 and an interest rate of 12 per cent will provide a return of Rs.120,000. If interest rates were to rise to 14 per cent, an investor would only need to invest Rs.857,143 to achieve the same amount of return.

When government bonds are earning 14 per cent, investors will only purchase the 12 per cent bonds if the price of the 12 per cent bonds is lower. In effect, the result will be a capital loss for those who bought bonds at 12 per cent. This will find expression in the value of that security in the secondary, or resale, market.

Re-investment risk

Another risk that needs to be considered is ‘re-investment’ risk. This risk occurs when financial instruments have a maturity date. When they mature, the investor may not be able to achieve as high a return as they received on the previous investment.

For example:

If you had purchased a 9.5 per cent deep-discount-bond worth Rs.10 000 on issue and held it to maturity, you would receive an interest of 9.5 per cent plus the repayment of the initial Rs.10 000. If, however, the interest rate had dropped over the holding period, you may only be able to reinvest your principal amount of Rs.10 000 at the latest prevailing market rate, lets say at 6 per cent. So, the same amount of money bought you a lower income stream.

Purchasing Power risk

Purchasing power risk refers to the impact of inflation or deflation on an investment. That is, investors expect a higher rate of return on the investments, should they expect the prices of goods and services go up. This is because of the simple reason that the purchasing power goes down in an inflationary period and unless the returns go up, the real rate of return earned on an investment would come down. For instance, if the required real rate of interest is 4% and the expected inflation in a year’s time is 2%, the actual rate of return should be at least 6%

Liquidity risk

The ability to acquire or dispose off an investment at a short notice without substantial discount in price is known as liquidity. Liquidity risk is therefore the risk that the investments are not purchasable / saleable at a reasonable cost within a reasonable time. Generally, Government securities can be bought and sold at a price almost equal to the quoted price and thus have no liquidity risk. But, investment in real estate properties, antiques, paintings etc., may require a long time to find a buyer and thus carry a high liquidity risk.

Exchange rate risk

Exchange rate risk arises when the investments are bought and sold around the world. An Indian investor who buys an American security denominated in dollars gets exposed to two types of risk:

  1. the uncertainty of the return on dollar investment and
  2. the uncertainty of return when the dollars are converted in to rupee.

If the dollar weakens against the rupee, the return on the investment should be sufficiently adequate to cover this depreciation in dollar.

Other Risks

  • Information risk : Information risk is the risk that the information on a particular investment may not be accurate (this may be brought about by deliberate misstatements by those promoting the investment or just by plain bias).
  • Political risk : Political risk is risk arising from changes in governments and changes in government policies.
  • Management risk : You also need to understand that where a fixed interest rate security agrees to pay-back face value, in a collective investment, such as a unit trust, the manager may actively buy and sell these securities. The skill of the manager will determine whether the total result of their activities achieves a capital gain or loss over any specific period.