What is the ‘Risk’ in an Investment and why is it the most important factor in investing?

In this article lets understand what is risk in any investment? What are the types of Risks you are exposed to when you invest? Can you completely avoid the risk? Why risk is the most important factor in investment and how does risk affect returns on an investment?

In my last article Difference between Debt and Equity and which one is better for you? I had broadly covered the risk and its types. Today let’s dive deep in the subject of risk. 

What is Risk?

We are constantly exposed to some or the other risk. Be it while travelling or while playing or while cooking or even while sitting idle.

While travelling we are exposed to the risk of accidents. If you move on a bicycle, there is a risk that another vehicle can hit you. Moving in a car has a risk of accident due to overspeeding, bursting of tyre or failing of the brakes. While flying in a plane, we are exposed to the risk of crash due to technical glitch or bad weather. 

When we play or do any physical activity we are prone to an injury. We have seen Marathoners dying of heart fail. We have seen trekkers getting permanent injuries.   

While sitting idle there is risk of not keeping your body fit. You are exposed to the risk of gaining fats due to inactivity. You are at a risk of catching up the ailments like diabetes or hypertension.

Cooking is a day to day activity in any household. But faulty Gas can cause disaster. Pressure cooker can explode, if not used properly. There is a risk of hot oil spilling and causing the burns.

Investment is not different. Every investment is exposed to some or the other risk at any given point in time. It is just that, not being from the field of investing, we do not understand it. Sometimes, even if we understand the risk, we simply ignore it.

What are the Risks in Investment?

Our investments are constantly exposed to some or the other risk at every point in time.     

Let’s understand them one by one.

Credit Risk:

Your intention and ability of repaying the loan is reflected in your Credit Score. Since the bank is exposed to the risk of default from a borrower, it will ensure that they pay the loan only to the ones who are more likely to repay the loans.

You would have come across to banks assessing your Credit Score or simply the CIBIL score when you apply for a loan from the bank. By assessing your CIBIL score banks simply make sure that you will return the money borrowed from them. 

Can you, as an investor do the same, when you invest your money. Well, Yes. Rather you must. Whenever you invest in Debt type of investment, you should check the credit score or Credit rating of the institution or the instrument where you are investing your money. 

As there is CIBIL for assessing an individual’s credit score there are credit rating agencies like CARE or ICRA for assessing the credit rating of the institutions, the banks, the companies and even the government.

Interest Rate Risk:

Your investment is constantly exposed to the risk of reduction of interest rates. RBI decides the interest rates in Indian Economy. In case RBI decides to decrease the Rate of Interest, also known as Repo Rate, you will have to invest at a lower rate of interest. 

It means that there is no guarantee that you will keep on getting the same interest rate in future too. Interest rate risk is applicable to Debt type of investments.

To understand the interest rate further read: What decides the ‘Rate of Interest’ in your investment?

Market Risk or the Volatility Risk:

Whenever you invest in an instrument which is related to the share market (equity investment), you are exposed to this type of risk. 

Since the share market prices keep on fluctuating, the value of your investment too, moves up and down. You always have a risk of losing value of your investment.

Concentration Risk:

When you invest a large amount of your total investment in any one instrument, you face the concentration risk. There is always a risk that this particular instrument may not do well. There is also a risk that this instrument will default. Hence the investment is diversified across the instruments.

Inflation Risk:

One litre of milk used to cost around Rs 30 in 2009-2010. Its costs around Rs 60 per litre today. The value of money has reduced to half in 10 years. Generally, your household expenses are going to double in the next 8 years. Now, if your investment does not more than double in the next 8 years, you are actually losing money.

The return on any investment should be looked in context to inflation. Suppose you are earning an interest of 6% in an FD. At this point, suppose the inflation is 5%. Your next earning on investment is considered as 6% minus 5% that is 1% only.

Other Risks:

There are some other risks such as Liquidity risk – the risk of not being able to withdraw the money you had invested whenever you wish to.

Reinvestment Risk – not being able to invest at the same interest rate as that of old rate, due to reduction in the rate of interest.

Can you avoid the risk?

The question is – can you avoid the risk of accident while travelling. No, you can not. But you can certainly ‘Manage the Risk’ 

While driving, you manage the risk by not overspeeding, by using the seat belts, by having airbags in your car, by driving carefully, by following the traffic rules. 

You can see that the risk of accidents always but you take the necessary measures to manage that risk.

Similarly, in investment, one needs to manage the risk by solid Risk Management principles.

You may like to read how the risk can be managed: 

What is Risk Profiling and why is it important? – Time to know yours

Asset Classes! What are they and what role do they play in your Investment

How does risk affect your investment?

We have seen that our investments are constantly exposed to the risks as mentioned above ‘What are the risks in investment?’

However, we need to understand one more ‘Very Important’ principle of investing. This principle says that – ‘More the the returns more is the risk’

Which mode of travel has higher speed? A bus or an Aeroplane?

In which mode of travel the chances of the person dying are more in case of an accident?

All of us understand that the higher the speed the higher are the chances of casualty. 

Similarly, in an Investment, higher the expected returns, higher is the risk. More on this in upcoming posts.

Conclusion:

We need to understand that Risk can not be avoided but risk can be managed. While investing, we as your investment advisor, constantly work on managing the risk. The returns are the outcome of good risk management.

As an aeroplane does not meet with an accident, every now and then, an investment with good risk management gives better results. We at Bonvista have always believed in focusing on risk management, the returns are taken care of automatically.

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