LEARNING CENTER
Level | Intermediate

WHAT ARE THE RISKS INVOLVED WITH INVESTING? HOW CAN YOU MANAGE THESE RISKS?

Everything in life carries an inherent risk. From any situation, if you want to reap rewards, you may have to take chances or expose yourself to some uncertainty. Similarly, when it comes to investing, risk and returns are two sides of the same coin. Stock market prices can move up or down depending on external factors. For example, the stock price of a company can jump up if foreign exports are rising or if the government passes favorable business policy and it can fall if the sales reduce due to change in consumer needs or if the government bans exports on goods.

The reality is that any product that is linked to the market movements and offers you the opportunity to earn returns will have certain risks involved. For instance, if you are someone who wants to earn returns through investing in the equity market, you have to be prepared to undertake the risks involved as well. Understanding these risks will help you plan for safeguarding your investments against them.

The types of investment risks that investors are exposed to are broadly summarized in the table below (in no particular order):

Business risk Equities and corporate bonds are prone to company-specific risks: in the case of sudden or unexpected management change, product failures, rising costs, and other risks to the running of a business, stock and corporate bond prices may fall.
Inflation risk In a high inflation environment, investors will need to ensure that their investment returns are enough to keep pace with or beat inflation. High inflation can also adversely impact the performance of companies’ share prices as their profitability may decrease as a result.
Liquidity risk Liquidity risk refers to a situation in which you cannot buy or sell your investments easily as they are illiquid- which means finding buyers or sellers is really tough. For example, if you have invested in a stock of a company that is not doing well, the value of your investment goes down. If you wish to sell but most other buyers think that the company is not going to recover, they will not buy the shares.  On the other hand you will also face a similar problem with investments which have fixed lock-in periods- you can’t sell them before they mature.
Interest rate risk

Interest rate risk is the possibility of a change in interest rates, which, in turn, impacts the prices of securities. When interest rates move up, prices of existing debt securities fall and money moves from equity to debt, which, in turn, reduces prices of equity. On the other hand, when interest rates fall, prices of existing debt securities rise and money moves from debt to equity, which, in turn, increases prices of equity.

Let us understand the relationship between interest rates and prices better through an example. In 2013, Ram bought a debt security which offered him 8% interest rate at Rs. 100. Next year the interest rates went up and the new debt securities issued offered 9% return and hence were more attractive to the investors. So, people were willing to pay only Rs. 95 to buy that debt security from Ram. Ram was upset and wished he had bought this security the next year. On the other hand, had the interest rates fallen to 7%, other investors would have been willing to offer a higher price to Ram to buy the debt security he held, because to them it would appear more valuable compared to the newer debt securities issued at the lower interest rate. At the end of the day it’s a simple demand and supply equation.

Re-investment risk Reinvestment risk refers to your inability to find suitable investment option in which coupon payments or maturity payouts can be reinvested at similar rates as earlier. This can also affect the reinvestment of equity dividends, where the other investments available do not offer such a high return. Let us consider an example to understand re-investment risk. In January 2014, Anup’s debt security, which used to give him 8% annual return, matured. Work was hectic and Anup didn’t have the time to reinvest this money, which was left unattended in his bank account for almost 6 months. By the time Anup came around to figuring out what he wanted to do with this money, it was September and interest rates had now fallen to 7%. Anup couldn’t find any security similar to his previous investment that would offer him the 8% return that he was getting earlier. This inability of Anup’s to find an alternative investment option that gave him at least the same return as earlier refers to reinvestment risk.
Credit risk This is when a company or entity that issues debt is in danger of not being able to meet its commitment on interest payments or capital repayments. Increased credit risk impacts share prices, the ability of a company to raise capital, and also affects bond prices.
Geo-political risk Geopolitical risk can be defined as the risk of a country's policies unduly influencing or upsetting political and social stability in a country or region. This can force companies to stop performing their usual business functions or affect it to a great extent.
Currency risk Currency risk is when unfavorable exchange rate fluctuations reduce the sales and profitability of a company, if the company is involved in importing and exporting of goods. It could greatly affect the value of any foreign investments. Even if you invested in a foreign fund for which you paid in Indian rupees but whose securities were priced in a foreign currency say the US dollar, exchange rate fluctuations will affect your returns.
Market risk Market risk also known as systemic risk, is when overwhelming events affect the global markets and the value of investments. This risk is both unpredictable and extremely difficult to completely avoid which is why it’s also termed systemic risk- the risk always present in a system. It cannot be mitigated through diversification, but you can hedge or use the right asset allocation strategy to lessen the impact. Systemic risk was seen in the 2008 global credit crisis, where the collapse of a very large and iconic US investment bank arguably triggered a systemic collapse in the US subprime mortgage market and threatened to do the same to the global banking and financial sector.
Emotional risk Let’s face it- people make emotional decisions. They can be impulsive and highly reactive to every market move- upwards or downwards. Think about the last time that the market was going up consistently. Did you wait for some time to see if it will rise further before you invested, or were you able to invest when the rise was just starting? Alternatively, did you not invest more aggressively after the market had been on a long bull run? The emotional impact of a constant market rise or a constant market fall can lead one to feel ecstatic or hopeless, and investment decisions can end up reflecting that emotion- leading to one being over aggressive or extra conservative. It’s much later after such decisions have been taken and the negative impact of such decisions are being felt that people realize that what manipulated and let them down was their own emotions. Emotions and consequently, investment decisions can also get affected by behavioral biases.
Shortfall risk Shortfall risk refers to the probability of you falling short of achieving your goal, and whether you are prepared to handle such a situation? For example, can you say with 100% certainty that you will be able to buy your dream house in 5 years, what if takes you 7 years?  Or can you say that you will not live more than 80, which is what you may have considered when you planned for a retirement corpus to last you post retirement? What will you do then?

How do you handle these risks?

Recognizing risks is important, but knowing how to deal with them is even more critical. In order to mitigate these risks, be certain to understand and implement the following simple strategies:

  • Become more aware: You should become more aware and you can do this by simply reading up and understanding more about the risks involved when you invest. This can give you the comfort and knowledge required to deal with them effectively. Also, fight the urge to act impulsively or emotionally and be aware of behavioral biases that can creep in and impact your decision making ability.

  • Identify your own risk profile and the inherent risk in a product: Knowing yourself well can help you make the right decisions to match your own thinking. Therefore it is very important to identify your own risk profile and the inherent risk in the investment product. You should then match it to your risk profile and your goal orientation.. For example, if you are a conservative person and your risk profile indicates a low-risk tolerance, it is advisable to build a portfolio with a strong safety orientation such as government bonds, short term debt and so on. But on the other hand if you are an aggressive person and your risk profile indicates a high-risk tolerance, your portfolio can consist of equity stocks, real estate and so on.

  • Understand the right risk - return balance for yourself: You should understand the right risk - return balance for yourself: Now that you know your risk profile and the risk involved in the various products, set a balance between the returns you want and right level of risk you can take while planning for your financial goals.

  • Manage your investment portfolio: Diversify your investments by holding a balanced mix of asset classes and investment options within each asset class. Remain disciplined and stick to your financial plan. If you have a diversified portfolio, you will feel comfortable in the knowledge that even though there are some asset classes which perform better than others at different points, this balance will ensure that you are better protected. Also, you should ensure that you retain an asset allocation that matches your goals, with enough liquidity in the portfolio, and diversification to protect returns. If your portfolio is concentrated in a few investments, you may have to deal with poor returns when you would like to cash in your investments. You must remember to stick to your financial plan and rebalance your portfolio when needed.

  • Invest for the long term: It is beneficial to stay invested for the long term. Buying and holding investments for a long duration will not only give you the best chance to maximize returns but also help reduce risk. Markets fluctuate – you may lose money as they go down, but if you stay invested for a long period of time, as and when the market recovers, you will gain. Not reacting to every single market move and being able to deal with market volatility with a sense of calmness is going to pay dividends over the long term. Remember that if you need your retirement corpus in place when you turn 60 and not when you’re 40, then your actions should reflect this availability of another 20 years in case there are market fluctuations.

  • Seek professional advice: You may not have the time or the expertise to do all of this regularly, so it is highly recommended that you consider professional advice from an expert investment advisor from time to time to figure out how to manage and deal with any risks to your investments.

  • Be prepared to ride and fasten your seatbelt: Lastly, fasten your seat belts and prepare yourself for the ride ahead. Yes, it may be like a roller coaster and if you are lucky, it could be quite smooth. Either way, embrace it, learn from it and enjoy it

Here is some food for thought. The same risks that can make you feel worried are also opportunities that can enable you to earn great wealth. The same situations and the examples that we shared earlier could also have been positive and helped you gain tremendously. This is because risk and returns are two sides of the same coin.
So hopefully this information has helped you realize that you don’t need to be scared of the risks related to investing, You just need to be smart, cautious and aware while planning your investment strategy and learn how to manage your investments well.

Consult an investment advisor to identify the right investment products for you.

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Key Takeaways

  1. There are risks involved in investing, which can impact the returns you make.

  2. You can protect against most known risks with some simple strategies.

  3. Start investing early and hold investments for the long-term to ride out volatile periods.

  4. Take help from an investment advisor to identify the right investment products for you.