Five Investment Risks that you would have never heard of
What comes to your mind when someone says RISK or this investment is risky? Risk for most of the people has only one meaning, losing the principal amount. In scientific language “Risk may be taken as downside risk, the difference between the actual return and the expected return (when the actual return is less), or the uncertainty of that return.”
Information risk – This is very important risk to understand. You take your financial decisions based on some information – this information is provided either by manufacturer of financial products or agents/distributors/advisors or the media. What will happen if this critical information is wrong or not complete? If you think this only happens at the time of buying insurance – you are absolutely wrong. This can happen in any financial product including mutual funds (you see an advertisement of 100% return in a year – these are point to point returns and completely misguiding), taking loans (interest rate shown as 9% but actually it is 16% – it is game of flat rate and reducing rate) or even simple products like tax-free infrastructure bonds.
Last year at the time of IDFC Infrastructure Bond – there was one advertisement claiming that the issue offers a tax-adjusted yield of 17.85% to investors. This is nothing but information risk. Someone rightly said “If you torture numbers enough, they will confess to almost anything”.
Systematic and unsystematic risk – Systematic risk is also known as market risk or economic risk or non-diversifiable risk and it impacts the full economy or share markets. Let’s say if interest rate will increase the whole economy will slow down and there is no way to hide from this impact. As such there is no way to reduce systematic risk other than investing your money in some other country. Unsystematic risk affects a small part of economy or sometime even single company. Bad management or low demand in some particular sector will impact a single company or a single sector – such risks can be reduced by diversifying one’s investments. So this is also called Diversifiable Risk.
Exchange rate risk – If you invest in debt or equity of some other country you will face exchange rate risk. If some of your US investments earn 10% in one year in dollar terms but the same year dollar loses 2% in comparison to rupee – your actual return will be 8%. NRIs are heavily impacted by this risk and they should take financial decisions after considering it. Recently international funds and gold gave superb returns, just because rupee depreciated in comparison to the Dollar and the Euro.
Interest rate risk – A change in interest rate will impact price of bonds (or non-convertible debentures). There is negative corelation between price of bond and interest rates – when the interest rates increase the price of bond will go down and vice versa. This risk can be reduced if you hold bonds till maturity. Interest rate risk also affects bank’s fixed deposit investors – he invests five lakh rupees at a prevailing rate of 9%. What will happen if interest rate increases to 10% – he will be losing 1% interest. A somewhat related risk to interest rate risk is, reinvestment risk – let’s assume that you made investment in a bond with 9% yearly interest. Interest rate reduced to 7% in one year, so in the next year when you receive interest and went back to invest, it was invested at lower rate.
Sovereign risk – it is also called country risk. To understand it better first you need to understand credit risk or default risk. This is most common and the most important risk in debt. Credit risk means there is risk that the debtor (to whom you are giving money) can default or situations may arise that he cannot pay. They say “credit risk is close to zero in government bonds” but close to zero doesn’t mean zero. What about present condition of PIGS countries – Portugal, Ireland, Greece and Spain. Even in India there have been instances where fixed deposits issued by government-backed companies deferred maturity payments by issuing additional bonds.
There are few other risks which impacts you directly or indirectly – inflation risk, country risk, institutional risk, liquidity risk, timing risk, volatility risk, valuation risk, political risk, government risk, regulator risk, execution risk, concentration risk, operational risk, event risk, company risk, geopolitical risk, sociopolitical risk, counter-party risk, reputation risk, commodity risk, management risk, principal risk, opportunity risk, prepayment risk, call risk, legal risk and I am sure I have missed lot others….
Oh so many risks and you thought only equities are risky. Now from the next time when you say risk free investment – first clarify which risk you are referring to.