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 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.
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.
- Investment risk is characterized as the likelihood or unpredictability of suffering losses as opposed to the anticipated return on investment due to a decline in the fair value of securities like bonds, equities, real estate, etc.
- Every sort of investment carries some risk, such as market risk, which is the danger that the invested amount will be lost, or default risk, which is the risk that the invested amount won’t ever be reimbursed to the investor.
- Investments made in foreign currencies are subject to currency risk. Currency risk is the possibility of losing money on foreign exchange investments due to fluctuations in exchange rates.
- For instance, if the value of the US currency declines relative to the Indian Rupee, the investment made in US dollars will be worth less.
Investment Risks Explained
Investment risk refers to the possibility of loss that an investor might incur when they put their money into sone sort of investment opportunity with the hop of earning good return. It means they is some element of uncertainty in almost all types of investment avenues that we try to access.
It is a general rule in the financial market that the higher the possibility of risk or the investment risk levels, the greater is the return expectation. The risk and return scenario can be assessed based on facts like how much liquidity the investment opportunity will be able to provide, how fast the money will be able to multiply and how much is the safety level.
Investors often use the process of standard deviation to calculate the risk associate with the financial product. It helps in measuring the volatility to which the asset prices are subject to after comparing them to the average performance of the asset prices in the past.
Understanding the basic ideas and concepts behind the risk and return strategy associated with any form of investments is important because that is the only way of managing investment risk or minimizing them.
- 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. This makes the study of managing investment risk very important in the financial market.
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. Another important point to note is that there are some assets that cannot be easily liquidated. Thus the investors demand more return for such investments as a compensation for holding them for a long time and not being able to use them as and when required.
#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. For this reason, it is very important to diversify investments into various opportunities so that the downfall of one asset is compensated by the rise or gain from the other. Otherwise the investor has to have a high level of investment risk tolerance.
#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. . It also applies for loans given by banks and financial institution to borrowers. The banks invest their money on borrowers by giving them loans and earns interest as return. However, if the borrower defaults during the loan repayment, it is a bad debt for the financial institutions and is a source of huge risk for them.
#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 which reduces their investment risk tolerance capacity.
#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. Preferences and needs of investors keep changing as per the changes in financial conditions or the state of the economy. An investment made for a particular purpose might lose its value due to certain sudden emergency. The investor has to cut short the timing of holding the investment, thus losing the return that they could have earned from it had they kept it longer.
#8 – Longevity Risk
Longevity Risk is the risk of outliving the savings or investments, particularly pertain to retired or nearing retirement individuals. . They might end up living longer than their own saving can sustain them or support them. This proves to be a huge risk because they usually do not have a steady source of income and their savings might be over due to lack of opportunity of getting replenished.
#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.
Let us try to understand the concept with a suitable example. Max is a 40-year-old individual with a good source of income. He has made some investments to make fund arrangement for his two children with an investment horizon of 15 years. The funds are invested partly in a liquid source that can be taken out as a nd when needed and partly in a fund that has a lock in period if 5 years.
It so happens that Max suddenly loses his job due to some problem in his company for which he was working. Now he is in dire need of money and is unable to arrange for funds to meet his expenses.
If we do the investment risk analysis, we notice that there is the horizon risk, where he cannot continue with his investment and has to access his liquid fund, thus breaking it. We also see the liquidity risk here because he cannot access the fund with a lock-in period when he needs it the most. So the above example highlights some investment risks that individuals or institutions might face.
How To Manage?
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, thus reducing the investment risk levels. 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: As per the investment risk analysis, 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).
Frequently Asked Questions (FAQs)
Minimizing this risk involves implementing strategies and practices to reduce potential financial losses. First, however, here are a few critical approaches to mitigate investment risk, including diversification, asset allocation, risk assessment and research, regular monitoring, risk management tool, and professional advice.
Determining whether or not to accept the risk associated with an investment in light of the projected returns is the goal of risk analysis and management. Standard deviation, Sharpe ratio, beta, value at risk (VaR), conditional value at risk (CVaR), and R-squared are standard approaches for calculating risk.
For investors trying to reduce their investment risk, portfolio diversification is choosing various investments within each asset class. Diversification among asset classes may also help to mitigate the adverse effects of significant market fluctuations on your portfolio.
This has been a guide to what is Investment Risk. We explain its types, along with examples, how to manage it and its features. You can learn more about investments from the following articles –