What Is Investment Risk?
Investment risk is defined as the probability or uncertainty of losses rather than expected profit from investment due to a fall in the fair price of securities such as bonds, stocks, real estate, etc. Each type of investment is exposed to some degree of investment risk like the market risk i.e., the loss on the invested amount or the default risk i.e., the money invested is never returned back to the investor.
Investment Risks Types
Let us look at different types of investment risks:
#1 – Market Risk
Market RiskMarket RiskMarket risk is the risk that an investor faces due to the decrease in the market value of a financial product that affects the whole market and is not limited to a particular economic commodity. It is often called systematic risk. is the risk of an investment losing its value due to various economic events that can affect the entire market. The main types of market risk include:
- Equity Risk: This risk pertains to the investment in the shares. The market price of the shares is volatile and keeps on increasing or decreasing based on various factors. Thus, equity risk is the drop in the market price of the shares.
- Interest Rate Risk: Interest rate riskInterest Rate RiskThe risk of an asset's value changing due to interest rate volatility is known as interest rate risk. It either makes the security non-competitive or makes it more valuable. applies to the debt securities. Interest rates affect the debt securities negatively i.e., the market value of the debt securities increases if the interest rates decrease.
- Currency Risk: Currency risk pertains to foreign exchange investments. The risk of losing money on foreign exchange investments because of movement in the exchange rates is currency risk. For example, if the US dollar depreciates to Indian Rupee, the investment in US dollars will be of less value in Indian Rupee.
#2 – Liquidity Risk
Liquidity riskLiquidity RiskLiquidity risk refers to 'Cash Crunch' for a temporary or short-term period and such situations are generally detrimental to any business or profit-making organization. Consequently, the business house ends up with negative working capital in most of the cases. is the risk of being not able to sell the securities at a fair price and converting into cash. Due to less liquidity in the market, the investor might have to sell the securities at a much lower price, thus, losing the value.
#3 – Concentration Risk
Concentration Risk is the risk of loss on the invested amount because it was invested in only one security or one type of security. In concentration risk, the investor loses almost all of the invested amount if the market value of the invested particular security goes down.
#4 – Credit Risk
Credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection. applies to the risk of default on the bond issued by a Company or the government. The issuer of the bond may face financial difficulties due to which it may not be able to pay the interest or principal to the bond investors, thus, defaulting on its obligations.
#5 – Reinvestment Risk
Reinvestment RiskReinvestment RiskReinvestment risk refers to the possibility of failing to induce the profits earned or cash flows into the same scheme, financial product or investment. It even states the uncertainty of not getting the similar returns when such funds are invested in a new investment opportunity. is the risk of losing higher returns on the principal or income because of the low rate of interest. Consider a bond providing a return of 7% has matured, and the principal has to be invested at 5%, thus losing an opportunity to earn higher returns.
#6 – Inflation Risk
Inflation RiskInflation RiskInflation Risk is a situation where the purchasing power drops drastically. It could also be explained as a situation where the prices of goods and services increase more than expected. Inflation Risk is also known as Purchasing Power Risk. is the risk of loss of purchasing power because the investments do not earn higher returns than inflation. Inflation eats away the returns and lowers the purchasing power of money. If the return on investment is lower than the inflation, the investor is at a higher inflation risk.
#7 – Horizon Risk
Horizon Risk is the risk of shortening of investment horizon due to personal events like loss of job, marriage or buying a house, etc.
#8 – Longevity Risk
Longevity Risk is the risk of outliving the savings or investments, particularly pertain to retired or nearing retirement individuals.
#9 – Foreign Investment Risk
Foreign Investment Foreign Investment Foreign investment refers to domestic companies investing in foreign companies in order to gain a stake and actively participate in the day-to-day operations of the business, as well as for essential strategic expansion. For example, if an American company invests in an Indian company, it will be considered a foreign investment.Risk is the risk of investing in foreign countries. If the Country as a whole is at risk of falling GDP, high inflation, or civil unrest, the investment will lose money.
Investment Risk Management
Although there are risks in investment, these risks can be managed and controlled. Various ways of managing the risks include:
- Diversification: Diversification includes spreading investment into various assets like stocks, bonds, and real estate, etc. This helps the investor as he will gain from other investments if one of them does not perform. Diversification can be achieved across different assets and also within the assets (e.g., investing across various sectors when investing in stocks).
- Investing Consistently (Averaging): By investing consistently i.e., investing small amounts at regular intervals of time, the investor can average his investment. He will sometime buy high and sometimes buy low and maintain the initial cost price of the investment. However, if the investment rises in the market price, he will gain on the whole investment.
- Investing for the Long Term: Long-term investments provide higher returns than short-term investments. Although there is short-term volatility in the prices of securities, however, they generally gain when invested over a longer horizon (5,10, 20 years).
- It is the risk of losing the money invested due to the fall in the fair price of the security.
- Securities with higher risk give higher returns.
- The risk mainly includes market risk but is not limited to market risk. There are other risk types like credit risk, reinvestment risk, and inflation risk, etc.
- Although investment risk pertains to almost all kinds of investments, this can be reduced by diversification, averaging out investment, and long-horizon investing.
Investment Risk is the uncertainty of losing the invested amount. All investments carry a certain degree of risk of loss, but by better understanding and diversifying the risk, the investor may be able to manage these risks. By better risk management, the investor will be able to have good financial wealth and meet his/her financial goals.
This has been a guide to What is Investment Risk and its Definition. Here we discuss investment risk types, including market risk, liquidity risk, concentration risk, credit risk, reinvestment risk, inflation risk, and so on. You can learn more about investments from the following articles –