The concept of investment risk pertains to the likelihood of experiencing losses or unpredictability in the fair value of securities such as real estate, stocks, bonds, and others, rather than potential gains. It is important to note that all types of investments are subject to some level of investment risk.
The three investment risks, including credit, market, and liquidity risks, are discussed below.
Credit risk is the risk that a borrower may not be able to repay a loan, causing the lender to lose the principal of the loan or the interest associated with it. This risk arises because borrowers may default, file for bankruptcy, or have their credit rating downgraded. Lenders use credit risk assessments to determine the likelihood of these events and decide whether to extend credit to a borrower. Credit risk is an important concept in finance, as it affects the profitability and stability of financial institutions.
Credit risks can be classified into the following categories:
- Default risk
- Concentration risk
- Country risk
- Downgrade risk
- Institutional risk
Market risk refers to the potential for losses in investments due to changes in market conditions, such as fluctuations in stock prices, interest rates, exchange rates, and commodity prices. Every investment involves some degree of market risk, and investors must assess and manage this risk to achieve their financial goals.
There are four types of market risks:
- Interest rate risk
- Commodity price risk
- Foreign exchange risk
- Equity price risk
One way to manage market risk is through diversification. Diversification involves spreading investments across different assets, industries, and geographic regions to reduce the impact of market volatility on overall portfolio performance. By diversifying, investors can mitigate the risk of losses in any investment and potentially achieve more stable returns over time.
Another way to manage market risk is through hedging. Hedging refers to taking an offsetting position in a related investment that moves in the opposite direction of the original.
Investors can also manage market risk by monitoring market trends and staying informed about global economic and political events that could impact investments. By staying up-to-date on market conditions, investors can make informed decisions about when to buy, sell, or hold investments.
Finally, it is important to remember that market risk is inherent in investing. No investment is completely risk-free, and investors must be prepared to accept some level of risk to achieve potential returns. However, investors can increase their chances of achieving their long-term financial goals by carefully assessing and managing market risk.
Liquidity risk refers to the possibility that an asset cannot be sold or bought quickly enough to prevent a loss in value or to meet financial obligations. This type of risk can be particularly acute during financial stress or crisis when buyers and sellers may become hesitant or unavailable. The businesses end up with a negative working capital when they can’t repay short-term liabilities.
Some examples of liquidity risk include the following:
- Due to exceptional losses or damages during operations, there is a difficulty in meeting short-term debt obligations.
- There is a failure to secure appropriate funding within a specified timeframe.
- The increase in material costs leads to a rise in manufacturing expenses for the company.
To mitigate liquidity risk, investors can diversify their portfolios by investing in a range of assets with different levels of liquidity. They can also maintain adequate cash reserves to meet short-term obligations or unexpected expenses. Additionally, investors can use financial instruments such as options and futures to hedge against potential losses due to liquidity risk.
Liquidity risk can be a significant concern for investors and financial institutions alike. By understanding the potential risks and taking steps to mitigate them, investors can help protect their portfolios and minimize losses during market stress or volatility.
Investment risks are inherent in investing, and all types of investments carry some risk. Investors must balance the potential return on investment with the associated risks, as the level of risk taken on is determined by how much money they could lose on their original investment. Investment risk can refer to both the possibility of a loss and the magnitude of that loss.
Investors should assess their risk appetite by analysing their capacity, interest, and willingness to take and manage risks, known as a risk profile. A thorough analysis of investment risks is necessary as both the objective component of the investment and the subjective factor of the investment decision.
When crafting an investment plan, investors must decide how much risk they will take. Understanding investment risks and balancing them with potential returns is crucial in making effective investment decisions.