Investment Risks

Investment risk is defined as the probability of losses relative to the expected returns from an investment. It is the likelihood of losing your investment value—wholly or partially—due to a fall in the prices of securities.

In this article, we discuss what is an investment risk in detail, outlining the features, types, and measures to manage these risks, and also discuss the risks associated with investing in mutual funds.

What is an investment risk?

In finance, investment risk means the possibility of loss that an investor might incur if the actual return from an investment is lower than their expected returns. In other words, it is the probability of losing some or even all of your originally invested funds. Financial risk is the chance of suffering losses on your investments against the expected return from the investment due to a fall in the value of the security. When you invest, you accept the inherent investment risk associated with that investment instrument.

Understanding the meaning of investment risk with an example

The meaning of investment risk is the degree of uncertainty or the potential for loss inherent in an investment instrument. As such, all investment avenues carry a certain degree of risk. Generally, the higher the risk quotient of an investment instrument, the greater its return expectation. In simple words, greater return expectations compensate for the higher risks involved in a particular investment instrument. For instance, investing in equity shares of a company is riskier than investing in government bonds since government bonds have a low chance of default. However, equity investments also carry the potential for higher returns compared to government bonds. The risk and return balance of an investment instrument is assessed based on several factors, like how liquid the investment is, how fast the investment will grow, and how safe the corpus will be.

Investment risks are generally assessed in historical terms. In other words, how investment instruments have performed historically and their historical returns. Investors generally calculate financial risks associated with an asset using standard deviation. Standard deviation measures the volatility of an asset’s price relative to its historical average within a given time frame. For instance, a highly volatile stock will have a high standard deviation, while more stable stocks will have lower standard deviation values.

Features of investment risks

The following list of investment risk features will help you better understand what is an investment risk:

• Uncertainty: Investment risk is the risk of losing your invested principal due to a fall in the price of the security.

• Relationship with returns: Generally, securities with a higher investment risk carry a higher return potential. Investors expect higher returns from assets that have a higher risk quotient.

• Types: Investment risks can be broadly classified into systematic risks (risks that impact the whole market) and unsystematic (specific risks that impact a particular industry or a company). Apart from this broad classification, assets may be subjected to different types of risks, including market risk, credit risk, reinvestment risk, inflation risk, and liquidity risk.

• Management: While all investment avenues carry different degrees of investment risks, there are various risk management strategies investors deploy to minimise uncertainties. Diversification, long-term investment horizons, and averaging are some common strategies for investment risk management.

Types of investment risks

Now that you know the meaning of investment risks, let’s look at the different types of investment risks:

Market risk

Market risks are systemic risks that can impact the whole market or a significant proportion of the market, resulting in your investment losing value. Market risk can be subdivided into the following categories:

• Equity risk: This financial risk pertains to share market investments. The market price of equity shares can fluctuate on the basis of different factors that affect their demand and supply. Equity risk is the risk of losing investment value due to a significant drop in the market prices of shares due to market events or political events.

• Interest rate risk: Interest rates in a market can fluctuate due to various reasons like inflationary pressures. If the central bank raises interest rates in the market to combat inflation, the market value of debt securities like bonds will drop because newly issued bonds will become more attractive. You may have to sell an older bond with a lower interest rate at a discount due to limited buyers.

• Currency risk: Currency risk is a market risk you bear when you invest in foreign markets. The value of your investments can change depending on the changing exchange rates between the domestic currency and foreign currency.

Liquidity risk

Liquidity risk relates to the investor’s ability to redeem their investment in the security for cash. It is the risk of not finding a market for securities, limiting the investor’s ability to buy and sell the security when they want. Liquidity risk may arise when there are limited buyers for the security in the market, which may force you to sell your assets at a lower price, resulting in losses. Liquidity risk can also arise when assets cannot be easily liquidated due to a mandatory lock-in period or associated premature withdrawal penalties.

Concentration risk

Concentration risk is the risk of loss you bear when you decide to invest in only one security or one type of asset class. In such cases, you run the risk of losing your entire investment if the market value of the selected security declines.

Credit risk

Credit risks are the most common types of investment risks associated with debt instruments like bonds. Credit risk is the risk that the bond issuer - company or the government - will default on the payment. Due to financial struggles, the bond issuer may not be able to pay the principal sum and interest, defaulting on their payment obligations. Generally, corporate bonds carry a higher credit risk than government bonds because the government is less likely to default on payments. Credit agencies issue credit ratings for bonds, underscoring their risk quotients.

Reinvestment risk

Reinvestment risk is a type of financial risk that arises when you reinvest the principal or income from the investment at a lower rate of return than the original return rate. In other words, it is the risk of reinvesting the original principal or income proceeds at a lower rate and losing out on returns. Reinvestment risks are most commonly associated with fixed-income assets like bonds.

Inflation risk

Inflation risk is the risk of losing the purchasing power of your invested funds due to the steady rise in the cost of goods and services. You have to bear this financial risk if the rate of return on your investment is lower than the prevailing inflation rate.

Horizon risk

Time horizon refers to the length of your investment holding period. Horizon risk is the risk of shortening the investment horizon of an asset you had planned to hold for the long term. Various factors like job loss or emergency expenses can force you to liquidate long-term investments early and lose out on potential returns from a longer holding period.

Longevity risk

As an investor, you also carry a longevity risk. This investment risk refers to the possibility of you outliving your investment corpus. In other words, your investment corpus is not sufficient enough to sustain you through the retirement years. As such, longevity risk is a common risk for retirees and those nearing retirement.

Foreign investment risk

As the name suggests, foreign investment risk is the risk associated with investing in foreign markets. Foreign investment risk includes multiple risks, including the possibility of fluctuating exchange rates, chances of civil or political unrest, falling GDP, and rising inflation. Any of these events can potentially risk your entire investment corpus.

How to measure investment risk?

Financial advisors use different statistical tools to measure investment risks. Standard deviation is used to estimate how much the price of the asset has fluctuated against its own average. Similarly, the Sharpe Ratio is used to estimate if the return on the investment is worth the risk it carries. Beta measures the amount of systemic risk involved in a particular security relative to the overall market. Financial advisors also use Value at Risk as a tool to estimate the investment risk associated with a particular portfolio.

Estimating your own risk appetite is crucial before you start investing and measuring risks. Risk tolerance levels of investors vary on the basis of factors like age, investment goals, income, and liquidity requirements. Considering these factors will help you gauge how much risk you are willing to take on. Additionally, you need to consider the risk-return ratio of investment instruments carefully. As mentioned earlier, riskier investments generally offer higher returns. However, you must estimate if the returns from the investment are worth bearing the risks using statistical measures like the Sharpe Ratio.

Example of investment risk

Let’s take an example to better understand what investment risk is. Suppose you are a 30-year-old freelancer with a high-risk appetite and a long investment horizon. Your investment portfolio consists of equity mutual funds, a mix of large and medium-cap stocks, and corporate bonds. You have also invested in ELSS funds for better tax savings and parked your emergency corpus in liquid mutual funds.

If we do an investment risk assessment on this portfolio, we find that there is horizon risk because your income is not guaranteed or steady like that of a salaried investor. In other words, you may have to stop investing or dip into your liquid corpus if there is a lack of freelancing opportunities or lean periods. Additionally, there is a liquidity risk associated with ELSS mutual funds, where you cannot withdraw from these funds within the first 3 years.

Explore these related articles to deepen your understanding and make informed investment decisions:

• What is risk return trade off

• What is portfolio risk

• What is Default Risk?

• What is systematic risk

• What is inherent risk

How to manage investment risks?

Each type of investment carries its own set of risks. As an investor, you need to learn how to manage these risks rather than avoid investing altogether. Here are a few strategies you can implement to manage investment risks:

Diversification

Diversification is the most basic strategy of risk management and minimisation. It is the process of spreading your investments across various asset classes to create a buffer for your portfolio. Diversification is linked to the concept of correlation and risk. If you diversify investments across assets with a low or negative correlation, you can effectively lower your portfolio's risk exposure. The logic is sound—even if one asset class or industry underperforms, others may perform better, preserving the overall value of your portfolio. A well-diversified portfolio that has investments spread across different asset classes like stocks, bonds, mutual funds, and gold can help you minimise loss potentials. Additionally, it is important to focus on diversification within each type of investment, varying investment by sector, industry, and market capitalisation.

Investing consistently (averaging)

Averaging is another prudent strategy to manage financial risks. Consistently investing money at regular intervals at more or less equal amounts over time can help smoothen the impact of short-term highs and lows.

Investing for the long term

Financial experts believe that long-term investors can earn better returns than those with a short-term investment horizon. Markets tend to perform better in the long run, averaging out short-term volatility. Investors prone to impulsive decisions due to short-term fluctuations fail to realise long-term gains.

Key takeaways

• Investment risk is the possibility or likelihood of suffering losses against the expected returns on an investment due to the declining prices of a security, like shares, bonds, real estate, etc.

• All investment avenues carry a certain degree of risk, which may be market risks, inflation risks, currency risks, horizon risks, reinvestment risks, credit risks, or liquidity risks.

• Generally, investments with a higher risk quotient yield better returns.

• Diversification, averaging, and long-term investing are some strategies investors can use to manage investment risks.

Conclusion

In summation, investment risk means the possibility of an investment’s actual return being lower than the expected return, resulting in potential losses. Since investment risk is a key characteristic of most investment instruments, you cannot completely bypass these risks. However, as an investor, you can deploy strategies like diversification to better manage investment risks.

Learning how to manage investment risks can help you better allocate funds and maximise the risk-to-return quotient of your portfolio. Additionally, if you are a low-risk investor, you can also add certain guaranteed return investments (which offer lower returns), like FDs, to your portfolio to create a hedge against investment risks.

If you’re looking to minimise investment risks and earn good returns when investing in mutual funds, a well-diversified portfolio is the key. You can rely on the Bajaj Finserv Mutual Fund Platform to curate a diversified portfolio. Here, you can compare 1000+ mutual funds to choose mutual fund schemes that best fit your risk tolerance levels and investment goals. You can even estimate your returns using the mutual fund calculator to see if the returns are worth the risks involved and make informed financial decisions!

Essential tools for all mutual fund investors