Different Types Of Investment Risks And How To Avoid Them

By | January 18, 2018

Are you one who thinks that fixed-income investments have no risk? Then you need to read this to dispel the myth that there are risk-free investments.

Different Types Of Investment Risks And How To Avoid Them

Every investment expert talks about risks. But hardly anyone explains what these ‘risks’ are. Want to know? Here you go. In simple terms, risk can be defined as the probability of something undesirable happening.

There are several risks associated with investments and these are called ‘investment risks’.  What is this risk? Investment risk is the probability of getting back less than what you invested or getting lower returns than expected. Does this apply only to equity investments? No, it doesn’t. Equity investments are certainly riskier when compared to other investments. However, all investments entail some amount of risk.

It is true that the risks are fewer in the case of fixed-income investments when compared to investing in stocks, futures and other such investments. But it is a general misnomer that there are no risks when you invest in fixed-income securities. Many of the risks involved in fixed-income investing are applicable to other investments as well. Here are the most important risks that you should be aware of. We also tell you how you can avoid them or lower their impact.

Interest rate risk

This risk is specifically associated with fixed-income investments.

What is it?

It is the risk that interest rate changes might affect your investments adversely. This is also known as market risk. But this risk is relevant only investors who trade fixed-income securities in the secondary market. Those who hold their investments till maturity will not be affected by this risk. This is because prices of fixed-income investments change along with changes in interest rates.

Generally, the price of fixed-income securities fall when interest rates rise and vice versa. So, it is possible that you might have to sell your securities at a loss if interest rates change. This is precisely what interest rate risk is all about. So, interest rates more directly affect fixed-income investments as opposed to other investments.

How to avoid it

You can protect yourself against this risk by investing in shorter maturity or duration securities or debt Mutual Funds. This is because rates hardly change in the short term. You can also invest in securities with different durations. Note that choosing floating interest rate investments can be risky in case interest rates are falling.

Additional Reading: Should You Invest In Post Office Schemes Or Mutual Funds?

Liquidity risk

This is higher in case of fixed-income investments as opposed to equity investments.

What is it?

The risk that the investment cannot be purchased or sold quickly enough to minimise losses or maximise returns. Similar to interest rate risk, this is more relevant to investors who trade fixed-income securities in the secondary market. Liquidity risk is usually measured as the spread between the bid and ask prices for the security. Bid is the price a buyer is willing to pay for the security while ask is the price the seller is willing to sell it at. However, some investments such as the bank Fixed Deposits have very low liquidity risks.

A bank Fixed Deposit is fairly liquid but there might be charges of 1%-2% for premature withdrawals. On the other hand, Corporate Fixed Deposits have very high liquidity risk and it is extremely difficult to withdraw your money before maturity. Generally, Government securities have very low liquidity risk because they are traded very often in high volumes.

How to avoid it

If you choose an auto sweep-in for your bank Fixed Deposit, liquidity risk can be minimised. In case of Corporate deposits, always try to invest in highly-rated instruments. The marketability of these securities will always be higher than other securities. So, you can sell them in the secondary market.

Additional Reading: How To Switch From Fixed Deposits To Debt Mutual Funds

Reinvestment risk

This risk applies to both equity as well as fixed-income investments.

What is it?

This is the risk that the money you reinvest on maturity of an investment will not earn the same return as the original investment. This is quite contrary to interest rate risks. That is, as interest rates rise, reinvestment risk declines. Let’s take an example. When your bank Fixed Deposit matures, you think of reinvestment but find that the current interest rate is lower than what you were getting, it is called reinvestment risk.

This is perfectly suited for today’s scenario where interest rates are falling. Suppose you invested in a Fixed Deposit at 10% three years ago; if it matures now, you will not find another bank Fixed Deposit that will get you the same return.

In case of bonds, reinvestment risk is high for callable bonds. Callable bonds are those which an issuer can call for surrender anytime during the period of investment. When the bond is called, you will be given back the amount invested along with the interest. So, when bonds are called by an issuer, the holder is subject to the risk that he/she may not to able to invest the proceeds at a comparable rate.

How to avoid it

The right way is to diversify reinvestment risk is by investing in other instruments like equities that offer higher returns. You could even consider equity Mutual Funds. Want to avoid reinvestment risks with callable bonds? Here’s a strategy. Investors can manage reinvestment risk by staggering potential call dates of their differing bonds, which reduces the chances that all bonds will be called at once.

Inflation risk

This is applicable more to fixed-income securities rather than equities because returns from fixed-income securities often don’t beat inflation.

What is it?

The risk that rising inflation may reduce the value of returns from your investments is called inflation risk. Inflation is a factor that keeps changing year-on-year. However, even though the amount of inflation may change, inflation is a constant risk factor. The average inflation for the last 5 years has been 7%. If you had invested in a security that yielded less than this, you would have lost money. It is important that you take this risk into account while you invest for your goals.

How to avoid it

Bond laddering will help in reducing inflation risk. Now, what is bond laddering? This means that you invest across bonds with different maturity periods. This way, you can keep reinvesting the maturity proceeds in investments that yield higher returns at that particular point in time. Another way you can avoid inflation risk is by investing in equities or Equity Mutual Funds for the long-term.

Equities have given an average of 15% returns per year in the last 10 years. You can also avoid inflation risk by investing in commodities such as gold. Generally, gold is considered as a hedge against inflation as it goes up along with the standard of living. You can invest in gold through coins and bars.

Additional Reading: Why Mutual Funds Score Over Stocks

Credit/default risk

This risk mostly applies to fixed-income investments.

What is it?

Credit or default risk is the risk that you may not receive the returns or the principal promised by the issuer of the security. This is a big risk for small investors, and it largely happens with bonds or Fixed Deposits issued by shady companies or unrated non-banking companies.

How to avoid it?

Credit rating agencies help you assess this risk. Securities with higher ratings have lower default risks.  In fact, Government securities have the lowest default risk.

Downgrade risk

This is only applicable to rated fixed-income securities.

What is it?

Downgrade risk is the risk that your investment’s credit rating may be downgraded by one or more credit rating agencies.

How to avoid it

You should always invest in highly-rated securities. Credit rating agencies issue ratings outlook for investments such as bonds. This is the agency’s view of creditworthiness of the issuer for next six months to two years. Look out for this outlook. If the rating outlook is negative, it is best to avoid investing in those securities.

So, now you know there are no risk-free investments. However, there are low-risk investments and ways to reduce risk when you invest. Also, remember that sometimes it is good to take risks if you want to beat inflation. But choose your investments wisely and always link them to your financial goals.

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Category: Investments

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