Types of Investment Risk that You should know

Above all, there will be certain investment risk in every asset that we invest our money into. Emphatically, we can reduce some of the risks by deploying the right investment strategies and risk management techniques. Accordingly, we define such risk investment risk as diversifiable risk.

Conversely, there will always be some investment risk that is omnipresent. In that case, such risks are non-diversifiable risk. With this in mind, let’s dive into the nine investment risks that every investor should know.

Part 1: Counterparty Risk

When you buy a financial instrument (e.g. a bond), there may be no secure method of delivery against payment. As a result, you may lose a part or all of your capital without receiving the actual good.

Also Known As: Default Risk

Part 1.1: Example

Hayden bought a new computer from an online retailer. According to the website, he needs to make the payment first. Thereafter, the retailer will deliver the computer to him within the next working day. Despite waiting for a week, Hayden did not receive the computer. Upon some checks, the retailer had gone missing!

Part 1.2: How to account for counterparty risk?

We may charge a risk premium to the party with higher risk of default.

Part 1.3: How to reduce counterparty risk?

For this purpose, we may request for a guarantor in order to proceed with the transaction. In the event of a default, the guarantor will be responsible to complete the transaction.

Part 2: Credit Risk

When a borrower is unable to fulfil his obligation, the lender will suffer a loss. Credit risk measures the probability of loss to this end. Chiefly, bank deposits, bonds, and other fixed income securities are subject to credit risk.

Part 2.1: Example

Let’s take the case of a bond to illustrate this. Generally, a credit rating company will assign a rating to the bond based on its level of counterparty risk. For instance, Moody’s may assign AAA to a high grade bond. On the contrary, Fitch may assign D to a junk bond (high risk of default).

Part 2.2: How to account for credit risk?

In order for bonds with higher credit risk to attract investors, it has to promise a higher yield. Otherwise, no investor will take on unnecessary risk for less than mediocre returns.

In addition, there may be an additional credit risk premium in order to account for the additional risk.

Part 2.3: How to reduce credit risk?

The issuer or the borrower may improve his credit history by repaying his loan on time. Furthermore, any proof of capital or a collateral will improve his credibility as well.

Part 3: Foreign Exchange Risk

When you invest your money into a foreign asset, you need to account for foreign exchange risk. This is because currency fluctuations may cause the invested asset value to rise or fall. Besides, the asset’s base currency may be different from your currency.

As a result, any movement in either currency will affect the cash flow of the transaction.

Also Known As: Currency Risk, Exchange Rate Risk, FX Risk

Part 3.1: Example

Hayden wants to invest in a piece of land in Malaysia for RM 100,000. At the present time, 1 SGD = RM 3.2. One month later, Hayden was about to sign the contract. However, the exchange rate fell and 1 SGD = RM 2.5. Instead of paying S$31,250 for the land, Hayden has to pay $40,000 now!

Part 3.2: How to reduce foreign exchange risk?

Investors can create a hedge to mitigate the foreign exchange rate risk. To demonstrate, we can use a forward contract or an option to protect against unfavourable currency movements.

Part 4: Interest Rate Risk

A change in the market interest rate may affect the value of certain assets. Evidently, bonds and other fixed income securities are interest rate sensitive.

Basically, the interest rate and the price of the fixed income security tends to move in opposite direction. That is to say that an increase in interest rate will reduce the value of the fixed income security.

Part 4.1: Example

Last year, a company released a three year bond that bears an interest rate of 3% per annum. Since it was a decent deal, Ivy decided to purchase the bond. Three months later, the market interest rate increases. Thereupon, there were new three year bonds that yields an interest rate of 4% per annum. Since the new bond appeals to other investors, the value of Ivy’s bond decreases.

Part 4.2: How to reduce interest rate Risk?

If the bond has a longer maturity date, then it will have a higher interest rate. This is to compensate the investor for the risk associated with the longer bond period.

Part 5: Liquidity Risk

Liquidity risk measures the ease of selling an asset in the market without significant monetary loss.

Part 5.1: Example

As a matter of fact, a property tends to have higher liquidity risk as compared to a stock. To demonstrate this, you may take a longer time to sell your house due to a lack of buyers. Besides, your perceived value of your home may be different from another buyer.

Part 5.2: How do to account for liquidity risk?

We may use bid-offer spread as an indication for liquidity risk. In detail, the smaller the spread, the lower the liquidity risk. Moreover, we can also use time to gauge the liquidity risk. In brief, the faster you can sell the asset at reasonable price, the lower the liquidity risk. What’s more, the smaller the size of the issuer, the larger the liquidity risk.

Part 5.3: How to reduce liquidity risk?

For this purpose, you should conduct a proper risk assessment. Without a doubt, determine how fast you can sell the asset back onto the market at a reasonable price. In addition, you may also use a forward contract to this end.

Part 6: Political Risk

Political changes or a country’s instability may affect your investment. Surely, you should expect higher volatility when you invests in countries that are not politically stable.

Also Known As: Geopolitical Risk

Part 6.1: Example

There is a constant dispute over who shall be the governor of a country. This reduces an investor’s confidence under those circumstances. Accordingly, the investment value of the asset will fall.

Part 7: Regulatory Risk

Changes in the law and regulation may disrupt a business, sector, or the entire market.

Part 7.1: Example

The government may impose stricter regulations for the manufacturing industry. Consequently, it may be no longer attractive to invest in a manufacturing company.

Part 8: Market Risk

Above all, market risk accounts for factors that affect the overall performance of the entire market. Since it is difficult to predict what will happen next, hence it is impossible avoid all the risks as well.

Also Known As: Systematic Risk, Undiversifiable Risk

Part 8.1: Example

As an illustration, the market may be going through a recession, natural disaster, or even a terrorist attack. Additionally, changes in interest rate or currency also contributes to market risk.

Part 8.2: How to reduce market risk?

Since there are N possibilities that contribute to market risk, we cannot reduce it through diversification. Instead, asset allocation is a possible hedge against market risk.

Part 9: Investment Risk

All things considered, investment yields only non-guaranteed returns. Consequently, there is a chance that the investment will not meet the investor’s expected return.

Part 10: Conclusion

Before you invest your hard-earned money, you should conduct a proper risk assessment for yourself. Thereupon, we will adjust your financial portfolio according to the risk that you are willing to undertake. For the most part, taking calculated risk is vastly different from taking unnecessary risk. Thereafter, we will deploy various investment strategies and risk management techniques for our portfolio. For example, we may use dollar cost averaging to mitigate the asset’s price fluctuation.

On balance, regular portfolio reviews helps to manage your expectation. In like manner, we will be able to make adjustments whenever necessary. This ensures that your portfolio will meet your financial objectives to this end.

Thoughts of the Day

What are some of the investment risk associated with your financial portfolio?
What measures have you undertaken to reduce the risk for your financial portfolio?
Will you consider to balance your portfolio with a participating policy?

PZL Blog | Singapore

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