What is Risk?
Risk may be defined as the chance that the actual outcome from an investment will differ from the expected outcome. So it is the probability that an expected event may or may not happen, or that an adverse event may happen. It is related to uncertainty of future outcomes. Alternatively it may be said to be the variability of returns from an investment. Thus, wider the range of possible outcomes, greater the risk.
Types of risk
Various sources give rise to risk factor in an investment. Broadly speaking, there are two types of risk: diversifiable risk and non-diversifiable risk. As their names suggest, diversifiable risk is that part of the total risk of a portfolio which can be reduced or diversified by investing into different types of securities, and non-diversifiable risk is that part which cannot be diversified away.
Non- diversifiable/ Market Risk: This is the systematic risk or market risk. These are risks inherent in the investment market and cannot be eliminated through diversification. These emanate from economy related general factors and thus have an impact on all the stocks in the market. Some stocks may be less affected by these factors, while others may be more affected. The degree may thus differ, but the effect is there on all the stocks. For instance, factors like change in government, war, depression, economic recession, growth in inflation, fall in GDP etc. impact the entire stock market. Hence this risk cannot be diversified away. The types of risks that come under this category are as under:
Re investment Risk: This is the risk that an investor may not be able to reinvest the interim cash flows received from a security at that same yield, due to subsequent fall in interest rates in the economy.
Example: Suppose you made an investment in a 12% bond today for 10 years. The interest received by you every year from this bond, may be reinvested by you at an interest rate less than 12% p.a. due to a falling interest rate scenario. This reduces your compounded return on the security.
Further, longer the time frame of an investment, higher the reinvestment risk. Logically, this risk is not there in securities like zero coupon/ deep discount bonds, or non dividend paying stocks, as there are no interim cash flows on these investments, only final cash flows are received at the end of maturity/ on sale.
Interest Rate Risk: This risk emanates from the fact that changes in interest rates in the economy will adversely affect the value of a security. This risk is more prominent for a fixed interest bearing security like bonds, debentures. Generally speaking, the market price of a security is inversely related to the direction of change in interest rates in the economy. Thus, the market price of a bond will fall due to rise in interest rates, and will increase with fall in interest rates.
Example: Company X issues 10% debentures as of date at its face value of Rs.1000 per debenture. If subsequently, the interest rates for comparable debentures in the economy rise to 12%, the other issuers in the market will start offering 12% interest on their new debenture issues. In order to compete with the new offers, Company X will have to provide an equivalent yield to the prospective investors. Since the interest rate was already locked at 10% and it is not feasible to change this frequently, the increased yield will have to be through a lower market price of these debentures. A lower purchase price of these bonds will increase the return to the prospective investors. Thus these debentures will start trading at a discount to their issue/ face value.
While the interest rate risk is directly present in fixed income securities, the rising interest rates also have a negative effect on equity stocks in three ways. One, an increased discount rate is used to value future cash flows. Two, increased borrowing costs for corporates leads to lower earnings for equityholders. Finally, increased yields on alternative fixed income security investments poses competition to stocks.
Purchasing Power Risk: This risk arises from a fall in purchasing power of the domestic currency due to inflation. Consequently the real value of an investor's assets/ investments may get eroded due to inflation. Thus something that requires Rs.1000 to be purchased today will require Rs.1100 a year late @10% inflation rate. Assuming your nominal income remains the same, this signifies a reduction in your purchasing power. Purchasing power risk is more prominent in case of investments in fixed income securities. Thus a bond with 12% fixed interest rate will erode in its market value, due to actual inflation rate being higher than the expected rate, which was not incorporated earlier in its interest rate. The relationship between nominal rate and real rate of return and inflation rate is as under:
Real rate = (1+ nominal rate) / (1 + inflation rate) - 1
Thus nominal rate of return remaining the same, higher the inflation rate, lower the real rate of return.
Exchange Rate Risk: This is the risk arising from an adverse movement of exchange rate of domestic currency vis-à-vis the foreign currency, thereby affecting the value of investments made by an investor.
Example: For instance you have made an investment in a foreign security worth US0. At the current exchange rate of Rs.50 to a dollar, your investment is worth Rs.10,000. Suppose sometime later, the value of Re vis-à-vis US dollar appreciates to Rs.40, your investment is now worth only Rs.8,000, i.e. a fall of Rs.2000 simply due to an adverse exchange rate movement. Likewise, if you have made an investment in shares of a domestic export oriented company, its revenues will fall due to such rupee appreciation (due to conversion into lesser amount of rupees of their fixed amount of dollar export bills), leading to a decline in its share price and hence in the value of your investment. However, import oriented units will benefit from such rupee appreciation as they will now have to shell out lesser amount of rupees to buy the same amount of dollars in order to pay for their import bills which are again fixed in dollars. Thus investors of such companies will benefit from this situation.
A natural corollary of such a situation is that an investor is advised to invest a portion of his investible amount in securities of export oriented units and another portion in securities of import oriented companies in order to diversify and eliminate the exchange rate risk
Diversifiable Risk: This is also called unique risk or unsystematic risk. It is unique to a single security, business, industry or country, and thus can be eliminated through diversification. Specific factors like death of a key executive in the company, strike in the factory, new competition etc. give rise to unsystematic risk. An adverse development in one company/ industry/ country is offset by favorable development in another company/ industry/ country. Hence having different types of stocks in the portfolio offers benefits of diversification by way of risk reduction, to an investor. Like they say “do not keep all your eggs in the same basket”. The best benefits of diversification are received when their returns are negatively co-related with each other. In that case, the same factor will affect them in two different directions and hence, negative effect on return of one security will be offset by a positive effect on return of the other security, and thus total return of the portfolio is not adversely affected to a substantial extent. Some of the types of unsystematic risk are business risk, financial risk, default risk, political risk, investment manager risk, liquidity risk, tax risk. Some of them are explained in detail hereunder:
Liquidity Risk: Liquidity is defined as the ability to sell an investment i.e. convert it to cash, quickly and with no/ little price concession. You may note that both features, time factor and competitive price, need to be present to qualify an investment to be liquid. By this definition, cash is the most liquid asset, followed by marketable securities. All listed securities which are actively traded are also considered liquid since they can be easily sold off at the current market prices. As against these, fixed assets like plant and machinery, real estate etc. are considered to be less liquid. These may be marketable, as in one can find a ready market for them where they can be sold, but they may not be liquid. Thus, if any one of the abovementioned two features is not present, the security is said to be not very liquid and thus be possessing liquidity risk.
Example: Investment in real estate is not considered to be a liquid investment as it may take time to liquidate and such a market is prone to lot of price fluctuations. The investor may thus, not get a reasonable price at the same time when he wants to sell it off. Likewise, some mutual fund/ insurance schemes also have a lock in period of a few years. The investor cannot liquidate them during the lock in period without a substantial loss to his original investment amount.
Political Risk: This is the risk that certain changes in political and economic conditions of a country will negatively affect an investment. It emerges primarily from doing business with another country, either through sourcing of raw materials, or by way of using them as markets for the company's final products. So investments made in securities of a foreign country, or in securities of companies relying heavily on foreign trade, expose the investor to this type of risk. Any kind of political unrest like a coup, assassination, civil war etc., or change in economic policies/ conditions of that country, upset the profitability of investments, made therein or in companies whose major part of revenues/ profits are dependent upon trade with that country.
Example: Company X manufactures handbags, for which it imports synthetic leather from Korea. Due to a civil war in that country, trade is disrupted and hence the supply of Company X's raw material. This affects its production and hence its profitability leading to a decline in its share price. This adversely affects the returns of investors of that company.
All the above types of risks should be kept in mind by an investor while devising a portfolio, in order to keep the total risk to a manageable level.
However, it is well acknowledged fact in the world of finance that “Higher the risk, higher the expected return”.