labels: investment - general
Managing investment risksnews
23 November 2005

Investing can be risky, but not investing is even more risky. Sanjay Matai, executive director, InfraSolutions India Pvt. Ltd., explains the different kinds of risk involved in investing

Everybody knows that investing can be a risky business. But, in fact, not investing is even more risky, as inflation erodes the purchasing power of your savings year after year. It is, therefore, important to understand

  • The different risks associated with investing
  • What types of risk are more critical for a given asset class
  • Which investments match your risk profile
  • How to minimise the impact of the risk on the returns

Credit risk
Credit risk is where the issuer of the security may default or not repay the principal and / or interest. Let us assume that you invested in a fixed deposit of a company. Later, if the company is in financial difficulties, it could delay or default on the payment of interest. It may not even return the principal amount. There have been many such cases in the past, including banks (especially co-operative banks).

Credit risk is affects mainly fixed deposits, corporate bonds / debentures, etc.

To minimise credit risk you should choose fixed deposit schemes or corporate bonds of only large and reputed companies. Rating companies like CRISIL, CARE, etc, independently rate many such schemes. Read these ratings to understand how risky your investment is going to be.

Liquidity risk
Liquidity risk comes up when a security is not saleable or tradable in the market. Your money gets stuck, creating what is called an asset-liability mismatch.

Most investments have a lock-in period. Or, there is penalty / cost that needs to be paid in case you prematurely withdraw your money. Suppose you invested in the public provident fund (PPF) every year, as it offers high tax-free interest and is also fully secured. The amount is locked in for 15 years. You would have a problem if in the interim you suddenly needed money urgently, and didn't have any other option available. You might then have to take a loan against the PPF, which would come at an interest rate higher than you are earning on your deposit. The difference between the two interest rates is your cost.

This risk is mainly associated with fixed deposits, bonds, government savings schemes, etc. It can also happen sometimes with mutual funds that make disastrous investment decisions and what are known as 'small-cap' shares, which are of lesser-known companies and, consequently, not traded in large volumes.

It may, therefore, be prudent to keep about three to six months of your estimated expenses in a savings account or other highly liquid options, which can be easily and quickly withdrawn. This will, in most cases, help tide over the emergencies and minimise costs that you may otherwise have to pay. Only, before taking any such step, it would be useful to calculate whether the cost of prematurely liquidating a fixed deposit is higher or lower than the amount of interest you will lose by keeping your money in a savings account.

Market risk
Market risk mainly affects freely tradable instruments such as stocks, equity mutual funds, futures and options, commodities, etc. The price of these securities depends a lot on demand and supply, apart from the fundamentals of the company concerned. They are highly volatile in nature, and an investor can make huge gains or losses. This risk is very easy to understand; most people are quite aware that the stock markets are risky.

Over the long term, the equity markets have mostly given good returns. But in the short term, they can result in huge losses (or huge gains). To manage market risk and make the best of equity investing, one should invest small amounts regularly and over a long period of time. History shows that this considerably reduces the chances of making losses.

Another risk is investing in a bad stock, which will not do well even if you hold it for a long period. For those who want to avoid this and take advantage of diversification, mutual funds are a better alternative to directly investing in equity, especially for the small investor.

Interest rate risk
Changes in interest rates mainly affect returns from debt-based instruments like fixed deposits, bonds, government securities, debt-based mutual funds, etc.

Let us assume that you made a fixed deposit in a bank at 7 per cent per annum for three years. Six months down the line, if the interest rates increase, you would not be able to take advantage of this as you are already locked in for three years. Conversely, if the interest rates were to drop, you would be better off. Say you invested in the PPF a few years back and were earning 12 per cent interest. Since then, the government has reduced the interest rate in stages to 8 per cent. But you are locked in for 15 years in the PPF scheme, and have to accept the lower rates.

You need to be aware of economic developments and accordingly make investments, so that you can take advantage of interest rate movements. If you feel that interest rates will rise in future, go for shorter maturity deposits. If you feel that interest rates will fall, take three- or five-year deposits. Or, if the interest rates are very volatile, you can choose floating rate bonds, so that you continue to earn market-linked returns.

Be aware of the risks you are taking when making investment decisions. Then match these risks with your risk appetite, risk profile and investment objectives, before you choose the option that best suits you. This will ensure that you manage risks well and get the best returns from your investments.

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Managing investment risks