Mahesh Pai highlights the different kinds of investment risks along with ways to mitigate them
When we speak about the types of risks in financial planning, each risk has a different philosophy, a different product and has different strategies to overcome.
To understand this, you may need a risk map which will bring you value with benefits and also understand the maximum risk that you can bear. Risk management begins with building a list with all the possible risks. Below are a few risks to be considered:
Taxation risk is the chance that tax rules may change resulting in losses due to higher than expected taxes. All of us have some sort of tax risk. For e.g. inheritance tax is one of them. India may not have it but you never know where your children will go, reside at in the future. You wouldn’t know and which tax law they will have to abide when they inherit your assets. So it is a very heavy risk and identifying tax risk is a major aspect of the risk map.
Opportunity risk is the fear of missing out risk on the easiest opportunities that come infront of you but you are scared of taking it. Many people say that if you don’t invest now then you will miss this opportunity and regret; it is a different kind of social pressure mixed with the risk. The best example here would be the crypto currency. Many people are buying it, just because of the fear of missing out without understanding the risks involved in it. You should ask yourself on how many times you have invested money just because you were scared of losing an opportunity. But also there are times when we don’t take risks because we feel that we will always have the same opportunity again in the future.
Market risk refers to the uncertainty associated with the investors’ investment decision. These risks mostly implies for investments like mutual funds, equities etc.
Markets can go up and markets can go down, but some investors believe markets will only go on top or they believe it will only go down; hence market risk is the most dangerous for these investors. As per reports and statistics, the markets
usually goes on top in the long run, we can understand this with a simple analogy. There is a small 10 year old boy playing with a yoyo, a yoyo goes up and comes down like a ball but with the help of the string while standing on the escalator. The momentum of the yoyo is like the pattern and the volatility in the stock market and since he is standing on the escalator he is eventually going on top, this defines the entire stock market in the long term. Market risk is not only associated with one company or industry but instead is dependent of the performance of the entire market.
Mortality risk is the risk of death. Considering the pandemic, the mortality rate has drastically increased. People are not only dying because of covid but also because of the side effects due to covid, like the black fungus or kidney failure post covid recovery etc. No matter how harsh this looks, the investor needs to manage his risk and invest taking all of this into account.
In this, the investor cannot meet his short term debt obligations due to the lack of liquid cash. The investor maybe unable to convert any asset into cash due to lack of buyers or an inefficient market.When the investor faces a cash crunch or liquidity issues, they never understand how instantly it happens. They have a lot of money but one day everything goes wrong and they lose their liquidity. It is the most uncertain risk of all other risks. Many rich people are asset rich and cash poor but they don’t agree to that because they assume that holding on too much liquidity is bad but knowing how much percentage of liquidity one must hold out of all their assets is what helps to curtail this risk.
Interest rate risk
Interest rates affect everything in and around but it mainly affects the investor’s equity portfolio, bond portfolio, loans and liabilities. Sometimes, it doesn’t affect directly. There is no way that an investor can control or mitigate the interest rates. It affects the loans and liabilities unswervingly and the returns on the assets. The best way to reduce this risk is to find the best way to ‘interest proof yourself’. Having an income apart from your business profits / salary and which is not determined by the interest rates will help in the long run.
Sequence of return risk
Sequence of return risk is the systematic flow of the returns on your investment without any disruption. Only when this momentum of income is attained, the investor is free from this risk.
You can understand this better with an example, when you buy a property, rent it out and after 20 years it has appreciated, what do you do want to do with it, sell it or renovate it? If you sell it without renovation then you may get 30-45% lesser value on your property but if you renovate it and give it out on rent then would you be able to recover the renovation costs with the regular rent? The real question is “When do you actually get the returns on your investment?”
Inflation risk is a risk that will undermine the returns on the investment which lead to a decrease in purchasing power. When inflation increases, the interest rates go high but your income still remains the same. Inflation affects everything around you – your bills, rent, commodities, fixed deposit rates and returns on every other asset. Hence, an investor must always invest a part of his portfolio which will beat inflation.
Longevity risk is the risk of the investor living for long. This is the most dangerous risk of all the above mentioned risks. It multiplies the risk of all other risks for longer he lives. It is also known as the risk multiplier. The longer a person lives the higher are the expenses, more income is needed and hence a proper plan is mandatory. There isn’t any way to avoid this risk but planning for it in advance is the key.
There are many ways to manage risks and diversification is one of the most popular ways. But this does not act as a cover or shield against the risk but if you are exposed to any of the risks then you are less likely to collapse
The writer is an investment consultant and business coach. Email: email@example.com