Understanding Risk: Key To Investment Decision-Making

Risk is an inherent part of investing. When money is put into any sort of investment, there is an element of uncertainty about the outcome. Investment risk is the likelihood of a financial loss or variance from expected returns. It is important to understand the basic concepts behind risk and return strategies associated with any form of investment because that is the only way of managing investment risk or minimising them.

Market Risk

The different types of market risks include interest rate risk, commodity risk, currency risk, and country risk. Interest rate risk is associated with fixed-income securities, such as bonds, and can lead to volatility in investment returns. Commodity risk refers to the changing prices of commodities such as oil or food grains, which are essential to the production process of many goods. Currency risk, also known as exchange rate risk, affects the value of returns accruing to an investor due to changes in exchange rates. Country risk includes geopolitical factors, the degree of political stability, the level of fiscal deficit, and the regulatory environment.

While market risk cannot be eliminated, investors can use hedging strategies to protect against volatility and minimise its impact on their investments. This includes strategies such as buying put options, utilising index options, and dollar-cost averaging. Additionally, investors can study currency profiles, watch interest rates, and consider investing in utilities and consumer staples, which tend to be more stable during economic downturns.

Interest Rate Risk

The impact of interest rate risk can be measured by a fixed-income security's duration, with longer-term bonds having greater price sensitivity to rate changes. This is known as "price sensitivity" and is an important factor in determining the value of a bond.

Overall, interest rate risk is an important consideration for investors, especially those holding fixed-income assets. By understanding and managing this risk, investors can make more informed decisions and protect the value of their investments.

Credit Risk

Lenders can use credit risk analysis models to determine the probability of default by a potential borrower. These models provide information on the level of a borrower's credit risk and help lenders make key decisions on whether to extend credit and the rate to be charged. High levels of credit risk can negatively impact lenders by increasing collection costs and disrupting cash flow consistency.

There are several types of credit risk:

• Credit default risk occurs when a borrower is unable to fully pay their loan obligation or is significantly past the due date for repayment. It may affect all credit-sensitive transactions like loans, bonds, securities, and derivatives.
• Concentration risk arises from exposure to a single counterparty or sector and can result in large losses that threaten the lender's core operations.
• Country risk occurs when a country freezes foreign currency payment obligations, leading to a default on its obligations. It is associated with political instability and adverse macroeconomic performance, which can affect the value of assets or operating profits.

To assess credit risk, lenders often consider the "five Cs of credit":

• Capacity: The amount of income a potential borrower has relative to their debt.
• Capital: The financial resources or assets of the borrower.
• Conditions: The terms and conditions of the loan, including interest rates and repayment schedule.
• Character: The borrower's credit history and repayment behaviour.
• Collateral: The assets or property that can be used as security for the loan.

By properly assessing and managing credit risk, lenders can make more informed decisions and lessen the severity of potential losses.

Foreign Investment Risk

• Economic and Political Risk: Country risk, or the uncertainty associated with investing in a particular country, is a significant aspect of foreign investment risk. This includes economic risk, which refers to a country's ability to pay back its debts and the overall stability of its economy. Political risk, on the other hand, pertains to the political decisions and climate within a country that could impact investors. For example, a country with an unfriendly political stance towards foreign investors may not be a wise investment choice.
• Currency Risk: Currency volatility is an additional layer of risk in foreign investments. When investing in a foreign market, investors must exchange their domestic currency for the foreign one, and vice versa when selling their investments. Unfavourable exchange rate fluctuations can significantly impact the value of investments and the profitability of companies operating internationally.
• Transaction Costs: Investing in international markets often comes with higher transaction costs. Brokerage commissions, local market charges, and fund manager fees tend to be substantially higher for foreign investments. This adds a layer of complexity and cost to the investment process.
• Liquidity Risk: Liquidity risk is prevalent in foreign markets, especially in emerging economies. This risk refers to the difficulty in selling an investment quickly without incurring substantial losses due to political or economic crises unique to the foreign country.
• Country-Specific Risks: Each country has its own unique set of risks, including sovereign default risk, regulatory changes, and geopolitical tensions. These factors can significantly impact the performance of investments within that country.
• Information and Regulatory Differences: International investors may face challenges in accessing information about foreign companies, as it may not be readily available or provided in a different language. Additionally, working with foreign brokers or investment advisors may pose challenges due to differences in regulatory frameworks and investor protections.
• Security and National Interest Concerns: Many countries have established government bodies, such as the Committee on Foreign Investment in the United States (CFIUS), to review and block foreign investments in specific sectors to protect national security interests. This adds a layer of regulatory complexity for foreign investors.

Horizon Risk

For instance, consider an investor with a long-term horizon who primarily invests in stocks. If their time horizon is suddenly shortened due to an unexpected event, they may be forced to sell their stocks at a loss to access cash quickly. This could disrupt their financial plans and impact their ability to achieve their investment goals.

To mitigate horizon risk, investors can consider the following strategies:

• Diversification: Holding a diverse portfolio of assets and investment options can help reduce the impact of horizon risk. Diversification ensures that even if one asset class underperforms, others may compensate for the losses.
• Risk assessment: Understanding and assessing the risks associated with different investments is crucial. Investors should carefully evaluate their risk tolerance and ensure that their investments align with their risk profile.
• Regular review: Periodically reviewing and rebalancing the investment portfolio can help manage horizon risk. This involves adjusting the portfolio allocation to maintain the desired level of risk and return.
• Professional advice: Consulting expert investment advisors can provide valuable insights into managing horizon risk. They can assist in crafting a financial plan that considers potential risks and helps protect against unforeseen events.

By implementing these strategies, investors can better prepare for horizon risk and make more informed decisions to protect their investments.

Frequently asked questions