by Kishore Sanjeeva Hegde, Chartered Financial Analyst (ICFAI)
An investment is the strategic allocation of fund with an expectation of achieving future monetary growth or recurring returns.Return and safety are two important parameters of investment choice. When it comes to investing in debt instruments, they are believed to be safe investment vehicles as compared to equity investment. Now, the question is whether the debt instruments may be considered as safe investments?
Not exactly! Let us discuss the various risk involved in investing.
- Market risk
The risk of investments declining in value because of economic or other events that affect the entire market. The main types of market risk are equity risk, interest rate risk and currency risk.
- Equity risk –applies to an investment in the Share market. The market price of shares varies all the time depending on investors sentiments, demand and supply. Equity risk is the risk of loss because of a drop in the market price of shares.
- Interest rate risk –applies to debt investments such as bonds. It is the risk of losing money due to change in the interest rate. For example, when the interest rate goes up, the market value of bonds drops.
- Currency risk –applies when you own foreign investments. It is the risk of losing money because of a movement in the exchange rate
- Liquidity risk
The risk of being unable to sell your investment at a fair price and get your money out when you want to. To sell the investment, you may be compelled to accept lower price. In some cases, it may become impossible to sell the investment at all due to lack of demand.
- Concentration risk
The risk of loss because your money is concentrated in single investment or only one type of investment. When you diversify investments, you spread the risk over different types of investment instruments, industries and geographic locations.
- Credit risk
The risk that the entity or company that issued the bond will run into financial difficulties and won’t be able to pay the interest or repay the principal at maturity. Credit risk applies to debt investments such as bonds. You can evaluate credit risk by looking at the credit rating of the bond. You may recall that recently IL&FS, one of the largest infrastructure financiers defaulted on inter-corporate deposits and bond repayments. Subsequently, rating agencies downgraded the company’s credit rating.
- Reinvestment risk
The risk of loss from reinvesting principal or income at a lower interest rate. Reinvestment risk will not apply if you intend to spend the entire regular interest payments or the principal at maturity.
6. Inflation risk
The risk of a loss in your purchasing power because the value of your investments does not keep up with inflation. Inflation erodes the purchasing power of money over time, hence the same amount of money will buy fewer goods and services. Inflation risk is particularly relevant if you own cash or debt investments like bonds. However, share prices rises in line with inflation. Real estate also offers some protection since landlords can increase rents over time.
- Horizon risk
The risk that your investing horizon being shortened due to any unforeseen event, such as loss of job. Such events may force one to sell investments that you were intended to hold for the long term. If the markets come down when you sell, you may be at loss.
Review your existing investments. Evaluate which risks affect you? Reorganise, re balance it accordingly.
Be wise, money-wise.