Understanding The Evolution Of Investment Risk

Investment risk refers to the degree of uncertainty and potential financial loss inherent in an investment decision. In other words, when you invest in something, there is no guarantee of a return, and you may even experience unexpected losses. However, a risky investment may also pay off with unexpected gains. Typically, as the potential for risk increases, so too does the potential for greater rewards or losses.

There are several types of investment risk, including horizon risk, concentration risk, market risk, interest rate risk, currency risk, inflation risk, liquidity risk, credit risk, reinvestment risk, longevity risk, and foreign investment risk. Each type of risk can impact an investment in different ways, and it is important for investors to understand their relationship with risk and their risk tolerance, which is influenced by their experiences, financial status, and future goals.

While it is not possible to eliminate investment risk entirely, investors can employ strategies such as asset allocation and diversification to manage both systemic and non-systemic risks. Additionally, understanding the nature of risk and taking steps to manage it can help investors put themselves in a better position to achieve their financial goals.

Inflation risk

Inflation can be calculated in two ways: as the overall increase in the cost of living, or for specific items, such as the cost of gas, groceries, or housing. The most common terms used to refer to inflation are CPI (Consumer Price Index) and RPI (Retail Price Index).

In its most basic form, the formula for calculating your real return is:

Real return = nominal return − inflation

As inflation increases, the interest payments lose more and more purchasing power, and the principal, when it is repaid after several years, will buy substantially less than it did when the investor first purchased the bond.

However, there are several financial instruments that can be used to counteract inflationary risks, such as Treasury Inflation-Protected Securities (TIPS) and variable-rate securities.

Interest rate risk

When interest rates increase, bond prices typically decrease, and vice versa. This occurs because the market value of existing bonds adjusts to align with the attractiveness of newly issued bonds offering higher or lower rates. As a result, investors may be unable to reinvest their money at the same rate of return as their original investment, creating an opportunity cost and making older bonds with lower interest rates less attractive. Consequently, the market values of such bonds decline.

The extent of interest rate risk depends on the bond's maturity and coupon rate. Longer-term bonds are more susceptible to interest rate fluctuations because investors are locked into a fixed rate for an extended period, making the bond's value more sensitive to interest rate changes. Bonds with lower coupon rates also tend to be more vulnerable to interest rate risk, as their lower interest payments become less appealing when rates rise.

To manage interest rate risk, investors can diversify their portfolios by choosing funds that hold bonds with varying maturities or investing in hybrid mutual funds that combine debt and equity markets. They can also opt for safer investments, such as floating-rate funds, which adjust coupon rates based on prevailing market interest rates, or short-term debt instruments that mature before the next interest rate change. Additionally, interest rate hedging strategies, such as using derivative instruments like options or interest rate swaps, can be employed to offset potential losses.

Credit risk

When an investor purchases a bond, they are essentially lending money to a corporation or government entity. In return, the borrower promises to repay the loan (principal) with interest over a certain period. Credit risk, or default risk, measures the potential for losses resulting from the borrower's inability to repay their loans. It helps investors understand the level of risk associated with an investment and whether the potential yield is worth the risk taken.

The Financial Crisis of 2007-2008 highlighted the importance of managing credit risk. The crisis was caused, in part, by inadequate oversight of mortgage-backed securities, resulting in banks trading toxic debt that imploded when borrowers could not make payments.

To manage credit risk, investors can diversify their portfolios, purchase bonds with investment-grade ratings, and stick to bonds with low- to intermediate-term issues. Additionally, investors can benefit from hedging instruments to safeguard their portfolios.

Market risk

The different types of market risks include interest rate risk, commodity risk, currency risk, and country risk. Interest rate risk arises from fluctuations in interest rates due to monetary policy measures, which can impact the value of fixed-income securities. Commodity risk refers to the changing prices of commodities such as crude oil, food grains, and other raw materials. Currency risk, or exchange rate risk, arises from changes in the value of one currency relative to another, affecting investors with international holdings. Country risk considers the degree of political stability, the level of fiscal deficit, proneness to natural disasters, and other factors that can impact the level of return on international investments.

While market risk cannot be completely eliminated, investors can use hedging strategies to minimise their exposure and protect their portfolios. Diversification, while not effective in mitigating market risk, can be a useful strategy for managing unsystematic risk, which is specific to a particular company or industry.

Business risk

While it is impossible for a company to completely shelter itself from risk, there are ways to mitigate the overall risks, such as adopting a risk management strategy and developing a strategic risk plan.

Frequently asked questions