Amiya Sahu pens down various risks that one should consider before investing
Last month, I came across a trading platform in which one could earn as much as 82% in a minute! Yes, you read it right and there is no error! In exactly 60 seconds, the wealth could increase from INR 10,000 to 18,200 or one lakh to one lakh eighty-two thousand. The platform is easy to operate, hence addictive; and is extremely risky.
We should have no doubt in that fact that every investment comes with a risk. We need to understand it before investing in any asset. As markets and assets differ in their return characteristics, so do in terms of risk. The risk-taking nature of investors also vary. Mostly, we are risk-averse; while some enjoy taking risk. The possible return from an asset has a direct relationship with its riskiness. This means a higher return, usually, will come with higher risk, and if we are not willing to take any risk, we should be content with lower returns. The irony is investors look for higher returns while not being ready to take appropriate risk. To be wealthier, one should be ready to take risk.
The simplest definition of risk is ‘uncertain possibilities’. Risk is always futuristic. We take risk every day in our personal and work life. Eating street food, which is very tempting and exciting, could be risky; over speeding is risky; there can be numerous such activities. There is a thrill and excitement in taking risk.
While investing, we encounter various types of risk. The important ones are explained below:
(1) Market Risk: Uncertainties which affect the market as a whole is market risk. Different markets have different risks and they have different return possibilities. Markets in which price fluctuations are not much are less risky. The debt market is an example. As the price of equity shares fluctuate much more, the equity market is riskier.
(2) Asset Risk: Are such which are unique to a particular asset. For example, the risk of equity shares of Infosys and Bajaj Auto will be unique – as these companies belong to different sectors offering different products / services. Within each market segment, different securities debt, equity, and others have different risk. Some have low, and some have high risk. They can be understood using credit
rating (in case of debt) and beta (in case of equity shares). A high beta stock is riskier than a low beta stock. As of 11 August 2020, Infosys had a beta of 0.47 while Indusind Bank had a beta of 1.63.
(3) Liquidity Risk: This arises if we are unable to sell an asset or find it difficult to convert an asset into cash. Certain safe investments are highly liquid as it is easy to find a buyer e.g. bullion, and foreign currency. Equity shares which are listed in a stock exchange, are liquid as well. We can sell them when the stock market is open. But all shares may not have similar liquidity. Mutual funds also have good liquidity.
(4) Default Risk: Default risk arises from non-payment of promised amounts. Hence, applies mostly to assets that have obligatory returns. The best example is the debt instruments which promise interest payments and return of the principal amount. When non-payment occurs, we get into a situation of default. One must consider a greater element of default risk with Ponzi schemes which promise very high returns than market returns. There are numerous examples when large companies have defaulted in payments to their investors.
(5) Inflation Risk: When our average returns are less than the average inflation rate, we have inflation risk. Our wealth erodes in such a situation. Due to COIVID impact, the returns from bank deposits have fallen below the current inflation rates.
(6) Re-investment Risk: refers to a situation when we are not able to protect the current rate of returns if we carry forward our investments in the same assets. This occurs if a particular investment is cancelled or the characteristics of the assets change which reduces the returns. Renewal of bank deposits and growth options in mutual funds encounter this risk.
(7) Longevity Risk: This arises when we live beyond the anticipated age and with an increase in life expectancy. In such a situation, we may face severe difficulties as we would have exhausted our savings.
Investing without the knowledge of RISK is like jumping into the middle of the sea without knowing how to swim
The writer teaches at Goa institute of Management. Email: amiyasahur@gim.ac.in
