Understanding Risk
Investors are exposed to various types of risk that are dependant on unique factors such as age, lifestyle and even personalities. This uniqueness determines the level of risk an investor is willing to take as well as their ability to withstand the risk. An investor willing to take high levels of risks normally expects higher returns in order to compensate for the risks.
Risk and return go hand in hand in finance. Greater potential returns are expected by an investor who is willing to take high amounts of risk. An investment on a government issued treasury bill, for example, is considered to be risk-free, implying that it is a low-risk investment and hence will yield low returns; whereas, an investment on a stock (share) from a corporation that can be faced with bankruptcy is more risky and should therefore yield more returns.
Risk-Free Investments
No investment is truly risk-free; however, there are securities that are exposed to exceptionally low risk and are thus considered to be riskless. These kinds of securities are usually used to form a baseline for risk analysis and measurement. Investors of these kind of securities normally require access to their investments immediately or when required. Examples include treasury bills, certificate of deposits and money market accounts.
Understanding Diversification
Diversification is a risk management technique that mixes a variety of investments in a portfolio. A diversified portfolio consists of a mixture of different asset types in an attempt to limit exposure to risk.
The implication here is that an investor’s portfolio should be constructed so that it has different kinds of assets, which will yield higher long-term returns and lower the risk of any investor holding the asset.
TYPES OF FINANCIAL RISK
In finance, risk is categorised into systematic and unsystematic risk. Investors are exposed to these two kinds of risk.
Systematic or market risk is caused by factors that are beyond the control of or are external to a company or an individual. All investments are exposed to systematic risk and can therefore not be diversified. These risks include inflation, interest rates, currency, liquidity and exchange rates—any risk that affects the overall economic market.
Unsystematic, specific or idiosyncratic risk is the risk of losing an investment due to hazards that are company or industry-specific. These risks can be caused by regulatory changes, changes in management, product recalls and competitors, among others. To minimise these risks, invest in many different assets or companies, which is called portfolio diversification.
Financial risks that impact an investment are illustrated below:
Market Risk
As explained above, this is the risk that the value of an investment will decrease as a result of changes in the market. Portfolio diversification normally does not eliminate this risk; hedging can however be used to eliminate some of market risk. Here are some factors that make up market risk:
- Inflation/Purchasing Power Risk, which is the potential increase or decrease of prices due to inflation that will have an effect on the price of goods and services.
- Currency Risk, which is the risk that there will be an increase in exchange rates.
- Equity Risk, which is the risk that stock prices will increase.
- Interest Rate Risk, which is the risk caused by an increas or decrease in interest rates.
Reinvestment Risk
This is the risk that future cashflows, for a coupon or the final return of the principal, will need to be reinvested in low-interest yielding securities. Reinvestment risks can be eliminated by investing long-term securities.
Political Risk
This is the risk that foreign investments will decrease in value due to changes in a foreign country’s policies, investment regulations or business laws. Political risk can be eliminated through portfolio diversification. Investors can also minimize this risk by hedging their portfolio against future problems.
Liquidity Risk
This the risk that an investment will not have an active buyer or seller when the investor is ready to make a transaction, or the risk that an investor will not be able to transact their investment for cash. It normally occurs when a company or financial institution is unable to meet its short-term debt obligations. An investor might find it difficult to convert assets into cash without giving up capital and income due to a lack of buyers or an inefficient market.
Tax Risk
This is the risk that an investment will lose value due to tax policies in a given country.
Legislative Risk
This is the risk that a new law or change in an existing law by a government could significantly impact an investment.