A Comprehensive Guide to Types of Investment Risk

Market risk is the possibility of losing money due to factors affecting the overall performance of financial market assets. Value at Risk (VaR) is a statistical metric depicting the historical distribution of losses. Typically used for investment portfolios, it provides a confidence interval, indicating the probability of surpassing a specified loss threshold.

Market risk includes a variety of elements, including stock risk, interest rate risk, and currency risk, all of which can have an influence on the value of investments. It is critical to mitigate these risks in order to maintain a robust portfolio.

• Equity Risk: The potential for financial losses due to fluctuations in stock prices. In investment portfolios, assessing equity risk is crucial for managing potential fluctuations in the value of stocks and ensuring a balanced and potentially resilient financial strategy.
• Interest Rate Risk: The definition of interest rate risk is the risk of changes in interest rates affecting the value of investments.
• Currency Risk: The potential for losses arising from changes in exchange rates.

How Can Market Risk be Reduced?

• Diversification: By spreading assets across several asset classes investors may potentially lessen the impact of market fluctuations. Diversification reduces the risk associated with a single form of investment.
• Long-Term Investment: Investing over an extended length of time may help investors weather short-term market swings. This method allows investors to ride out market volatility while reaping the benefits of possible investment growth over time.
• Hedging: It is the use of financial products such as options or futures to offset prospective market losses. Hedging is a method of protecting against adverse market fluctuations.

The analysis of investment portfolios involves a careful examination of both systematic and unsystematic risk to make informed decisions about diversification strategies.

Another type of investment risk that investors must consider is liquidity risk. The ease with which an asset or security may be purchased or sold on the market and converted to cash is referred to as liquidity. One can define liquidity risk as the possible difficulty of selling an asset without significantly affecting its price.

Liquidity risk is classified into two types: 

1. Funding liquidity risk 
2. Market liquidity risk

Liquidity risk can be caused by a variety of circumstances, one of which is mutual funds investing in less liquid securities that aren’t easily exchanged on exchanges. When asset management companies (AMCs) convert these assets into cash, this lack of marketability may result in significant expenses.

While most mutual funds in India maintain liquidity, certain fund types are more vulnerable to risk. Closed-ended credit-risk funds, for example, have a higher level of risk. Similarly, funds that invest in lower-quality bonds face heightened risk.

SEBI requires liquid funds to hold at least 20% of their assets in liquid assets such as cash and government securities. The meaning of liquid funds is a short-term investment scheme that matures in a maximum of 91 days.

How Can Investors Manage Liquidity Risk?

Diversification is the practice of spreading assets across several asset classes and funds in order to increase overall portfolio liquidity. Monitor economic and market circumstances, as well as the individual assets in the portfolio, on a regular basis to predict possible liquidity issues. Maintain a separate emergency fund in highly liquid instruments to fulfil short-term financial demands, eliminating the need to sell investments in poor market situations.

Concentration risk is among the many different types of investment risk. It is the danger of a drop in the value of an investment portfolio or financial institution when certain exposures, whether individual or pooled, move unfavourably together. The issue with concentration risk stems from the likelihood of a significant loss that may be difficult to recover from, perhaps leading to the portfolio’s liquidation. 

The following are the types of concentration risk: 

Credit concentration risk: Credit concentration risk arises when a financial institution or investor has a large exposure to a single borrower or a group of borrowers. This risk becomes more obvious if the borrower fails, potentially resulting in significant losses that might jeopardise the institution’s or investor’s financial viability. To avoid this risk, institutions and investors should carefully monitor and diversify their credit exposure, spreading it over many borrowers.

Sector concentration risk: Sector concentration risk occurs when a portfolio or organisation has a significant exposure to a single industry or sector. This risk becomes serious if the industry has a downturn or obstacles that negatively impact its performance, potentially resulting in losses. Diversifying across sectors is one way to potentially mitigate the danger of sector concentration.

Geographic concentration risk: Geographic concentration risk is another type of risk in investment management. It is the possibility of loss when a portfolio or financial institution has a significant exposure to a certain geographic location. This risk may be caused by regional, economic or political instability, as well as foreign occurrences such as natural catastrophes.

Diversification across many locations is recommended to mitigate geographic concentration risk. Regular assessments of exposure to various geographic locations are critical for investors and financial institutions, allowing them to make necessary portfolio modifications. Investors can invest in international mutual funds to potentially mitigate geographic concentration risk.

Diversification across several areas is advised to reduce the risk of geographic concentration.  Investors can avoid regional concentration risk by investing in foreign mutual funds. Similarly, the Concentration Risk Assessment is an important component of risk management since it involves the examination of asset distribution within a portfolio to determine the possible impact of high concentration levels on overall risk.

Let’s understand some related concepts to concentration risk.

Concentration Risk Assessment: The assessment of concentration risk is analysing the distribution and exposure of assets within a portfolio to determine the possible impact of high concentration levels on overall risk.

Concentration Portfolio Analysis: This entails analysing the asset distribution within a portfolio. Concentration levels can be quantified using measures such as the Herfindahl-Hirschman Index (HHI) or concentration ratios.

Transaction Cost Analysis: Examining the transaction costs associated with portfolio modifications might provide light on the practical difficulties of diversification. High transaction costs may make it difficult to reduce concentration.

How Can Concentration Risk be Reduced?

Some strategies for reducing concentration risk are:

• Diversify your assets among asset classes, sectors, and geographic locations. Diversification can assist to lessen the impact of poor performance in one area.
• Set explicit risk restrictions for certain assets, sectors, or geographies. This ensures that concentration stays within established parameters, minimising overexposure to danger.

Among the different types of investment risk, credit risk is an important factor to consider. 

Credit risk meaning is the possibility of suffering a financial loss as a result of a borrower’s failure to repay a loan. In essence, it refers to the chance that a lender may encounter difficulties in collecting both the principal and interest owing, resulting in cash flow interruptions and increased collection expenses. Lenders can decrease credit risk by evaluating a borrower’s creditworthiness based on characteristics such as current debt commitments and income levels. 

The main types of credit risk are as follows:

Default: Default is the most common sort of credit risk. It represents the possibility that a borrower may fail to satisfy repayment commitments. 

Credit Spread Risk: This is caused by changes in the yield differential between risk-free and risky assets, which affects the cost of lending. 

Concentration Risk: This occurs when lenders have an overabundance of exposure to a single industry or borrower, increasing susceptibility. 

Country Risk: This originates from a borrower’s country’s economic and political factors, which impact their capacity to repay.

How to Potentially Mitigate Credit Risk?

​​To mitigate credit risk, investors may use measures such as rigorous credit evaluations, loan portfolio diversification, setting exposure limits, leveraging collateral, and monitoring borrower financial health. Furthermore, implementing strong credit risk management rules and staying current on economic and industry developments can improve the capacity to anticipate and resolve possible credit issues.

The possibility that the cash flows created by an investment would offer lesser returns when reinvested in a new venture is referred to as reinvestment risk. This risk stems from the unpredictability of current interest rates or investment possibilities at the time of reinvestment. When an investment, such as bonds or dividends, matures or pays interest, the investor must find a new investment that provides equivalent or greater returns. If interest rates have fallen or market circumstances are adverse, reinvested money may produce lesser returns, thereby reducing the total profitability of the investment portfolio.

How to Avoid Reinvestment Risk?

• Non-Callable Securities Investing:

Investors can manage investment risk by selecting non-callable securities since issuers cannot “call back” or redeem the securities before maturity, offering a greater trust in cash flow and eliminating a requirement to reinvest prematurely.

• Zero coupon bonds 

A form of investment risk control would be zero coupon bonds. These pay no interest on a regular basis but are sold at a discount. These investments may lower reinvestment risk since there are no interest payments to reinvest. The bonds are instead issued at a discount to face value, which is the primary driver of returns. Because the bonds expire at face value (or “par value”), there is no reinvestment risk because no monthly interest payments were received to reinvest.

• Bond Ladder

Bond laddering entails investing in bonds having staggered maturities. As shorter-term bonds mature, the proceeds can be reinvested at market rates, assisting in risk management while retaining accessibility and flexibility. This is a form of investment risk control that may work for investors.

• Actively Managed Bond Funds

Portfolio managers can respond to shifting market conditions thanks to professional management in actively managed bond funds. They can change the fund’s portfolio in response to interest rate swings, possibly reducing reinvestment risk.

The meaning of Inflation risk is the chance that unexpected inflation could make an investment or income stream worth less in the future. Market risk refers to the possibility of investment underperformance owing to variables such as inflation, whereas nominal return assesses returns without taking inflation into account.  What matters is the purchasing power, which is how much your money is worth after considering inflation.

Inflation means money becomes less powerful over time. If you don’t see inflation coming, the money you make from an investment or the future value of something you own might not be as much as you thought.

How To Mitigate Inflation Rate Risk?

The fundamental technique for mitigating inflation rate risk is to include an inflation premium in the projected interest rate or needed Rate of Return (RoR) on an investment. This means that investors or lenders account for a higher rate of return to compensate for the anticipated loss of buying power caused by inflation. Individuals attempt to guarantee that their investments create returns that outperform the rate of inflation, protecting the actual worth of their money over time by factoring in this inflation premium. In an ever-changing economic landscape, this technique is a proactive tactic intended at potentially mitigate the negative impacts of inflation and retain the buying power of an investment.

Horizon risk and longevity risk are related to the period of the investment.

Horizon Risk

The possibility that your investing time horizon will be abruptly reduced is known as “horizon risk.” This may occur due to personal emergencies where you may require the money invested. This can require you to sell certain investments, even ones you had planned to stay onto for a long time. You may lose money if you are compelled to liquidate investments during a low market.

How to Mitigate Horizon Risk?

You may diversify your portfolio with a few short-term assets to protect against horizon risk. Short-term bonds or funds in a high-interest savings account might be used as an emergency reserve. These investments will help you minimise your losses in the event that you are forced to sell.

Longevity Risk

Longevity risk is the potential for life expectancies and true survival rates to exceed earlier projections or pricing assumptions, which might result in an unexpected increase in the need for cash flows from pension funds or insurance firms. 

This risk arises from the rising trends in policyholders’ and pensioners’ life expectancies as well as the growing number of people reaching retirement age. Payout levels may surpass the initial projections provided by funds or firms as a result of these trends. Annuities, especially those that ensure policyholders’ lifetime payouts, and defined-benefit pension plans are the plan types most susceptible to increased longevity risk.

How to Mitigate Longevity Risk?

Longevity risk can be reduced by strategically managing underlying assets, asset allocation, and yearly income withdrawals from the pension. A lifelong annuity or pension is a financial product that is specially designed to handle longevity risk.

Foreign investment, put simply, is the study of capital transfers that occur between nations. Individual investors may allocate funds to overseas bonds or stocks as a hedge against inflation or to help diversify their holdings. However, these investors typically have a high threshold for risk. However, there are additional dangers associated with these investments called foreign investment risk.

Some of the types of risk in the foreign exchange market are as follows:

Generally speaking, investments in nations with stable political situations are seen as less hazardous. However, political instability can have a negative impact on investments. Examples of this include frequent changes in administration, societal discontent, and violence in politics. 

Natural catastrophes, like hurricanes, floods, or earthquakes, can seriously harm infrastructure and interfere with company operations. Foreign investors may suffer financial losses as a result of this.

How to Mitigate Foreign Investment Risk?

Purchasing foreign assets like mutual funds can help spread risk over a variety of markets and offer diversification benefits. Among other factors mentioned above, currency fluctuations, however, can neutralise the benefits of diversity, particularly if the investor’s home currency appreciates to the overseas assets’ currencies.

A straightforward yet effective idea that aids in assessing the possible risks and benefits of an investment is the risk/reward ratio. You may make more informed judgments about where to invest your money by weighing the amount you stand to gain against the amount you stand to lose.

In finance and investing, the risk/reward ratio is a concept used to calculate the possible profit or loss on an investment. The process of figuring out if an investment is risk-worthy is straightforward. The calculation of the risk/reward ratio involves dividing the possible return on an investment by the possible loss. 

Understanding and analysing the risk/reward ratio before investing is vital. It protects investors from potential losses and allows them to potentially achieve their financial goals while investing in schemes with risk-levels they are comfortable with.

• To put it simply, investment risk is the chance that an investment will not provide the anticipated returns or that money will be lost. Several types of investment risk exist no matter the investment that you choose.
• A significantly overlooked risk in the different types of investment risk is credit risk. 
• Credit risk is the possibility of suffering a financial loss as a result of a borrower’s failure to repay a loan
• Concentration risk is among the different types of investment risk. It is the danger of a drop in the value of an investment portfolio or financial institution when certain exposures, whether individual or pooled, move unfavourably together
• Inflation risk meaning is the chance that unexpected inflation could make an investment or income stream worth less in the future.
• A straightforward yet effective idea that aids in assessing the possible risks and benefits of an investment is the risk/reward ratio
• The fundamental technique for mitigating inflation rate risk is to include an inflation premium in the projected interest rate or needed rate of return (RoR) on an investment.