RISK

Definition

“Risk is the potential for variability in retruns.”An investment whose retruns are
fairly stable is considered to be a low risk investment whereas an investment
whose returns fluctuate significantly is considered to be a high risk
investment.Equity shares whose returns are likely to fluctuate widely are
considered risky investment.

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What Does Risk Mean?

The chance that an investment's actual return will be different than expected. Risk
includes the possibility of losing some or all of the original investment. Different versions
of risk are usually measured by calculating the standard deviation of the historical returns
or average returns of a specific investment. A high standard deviations indicates a high
degree of risk.

In one definition, "risks" are simply future issues that can be avoided or mitigated, rather
than present problems that must be immediately addressed.

The risk is then assessed as a function of three variables:

1. the probability that there is a threat

2. the probability that there are any vulnerabilities
3. the potential impact to the business.

Investment Risk

Risk is an inherent part of investing. Generally, investors must take greater risks to
achieve greater returns. Those who do not tolerate risk very well have a relatively smaller
chance of making high earnings than do those with a higher tolerance for risk.
It's crucial to understand that there is an inescapable trade-off between investment
performance and risk: Higher returns are associated with higher risks of price
fluctuations. Stocks historically have provided the highest long-term returns of the three
major asset classes and have been subject to the biggest losses over shorter periods. At
the other extreme, short-term cash investments are among the safest of investments when
it comes to price stability, but they have provided the lowest long-term returns.

Over short periods—even periods lasting a few years—lower-risk investments may

provide better returns than higher-risk investments. But historically over long periods,
riskier assets have provided higher returns.
There are various types of risk. We will discuss a few here:

Personal Risks

This category of risk deals with the personal level of investing. The investor is likely to
have more control over this type of risk compared to others.

Timing risk is the risk of buying the right security at the wrong time. It also refers to
selling the right security at the wrong time. For example, there is the chance that a few
days after you sell a stock it will go up several dollars in value. There is no surefire way
to time the market.

Tenure risk is the risk of losing money while holding onto a security. During the period
of holding, markets may go down, inflation may worsen, or a company may go bankrupt.
There is always the possibility of loss on the company-wide level, too.

Company Risks

There are two common risks on the company-wide level. The first, financial risk, is the
danger that a corporation will not be able to repay its debts. This has a great affect on its
bonds, which finance the company's assets. The more assets financed by debts (i.e.,
bonds and money market instruments), the greater the risk. Studying financial risk
involves looking at a company's management, its leadership style, and its credit history.

Management risk is the risk that a company's management may run the company so
poorly that it is unable to grow in value or pay dividends to its shareholders. This greatly
affects the value of its stock and the attractiveness of all the securities it issues to
investors.

Market Risks

Fluctuation in the market as a whole may be caused by the following risks:

Market risk is the chance that the entire market will decline, thus affecting the prices
and values of securities. Market risk, in turn, is influenced by outside factors such as
embargoes and interest rate changes. See Political risk below.

Liquidity risk is the risk that an investment, when converted to cash, will experience loss
in its value.

Interest rate risk is the risk that interest rates will rise, resulting in a current investment's
loss of value. A bondholder, for example, may hold a bond earning 6% interest and then
see rates on that type of bond climb to 7%.
Inflation risk is the danger that the dollars one invests will buy less in the future because
prices of consumer goods rise. When the rate of inflation rises, investments have less
purchasing power. This is especially true with investments that earn fixed rates of return.
As long as they are held at constant rates, they are threatened by inflation. Inflation risk is
tied to interest rate risk, because interest rates often rise to compensate for inflation.

Exchange rate risk is the chance that a nation's currency will lose value when exchanged
for foreign currencies.

Reinvestment risk is the danger that reinvested money will fetch returns lower than
those earned before reinvestment. Individuals with dividend-reinvestment plans are a
group subject to this risk. Bondholders are another.

National And International Risks

National and world events can profoundly affect investment markets.

Economic risk is the danger that the economy as a whole will perform poorly. When the
whole economy experiences a downturn, it affects stock prices, the job market, and the
prices of consumer products.

Industry risk is the chance that a specific industry will perform poorly. When problems
plague one industry, they affect the individual businesses involved as well as the
securities issued by those businesses. They may also cross over into other industries. For
example, after a national downturn in auto sales, the steel industry may suffer financially.

Tax risk is the danger that rising taxes will make investing less attractive. In general,
nations with relatively low tax rates, such as the United States, are popular places for
entrepreneurial activities. Businesses that are taxed heavily have less money available for
research, expansion, and even dividend payments. Taxes are also levied on capital gains,
dividends and interest. Investors continually seek investments that provide the greatest
net after-tax returns.

Political risk is the danger that government legislation will have an adverse affect on
investment. This can be in the form of high taxes, prohibitive licensing, or the
appointment of individuals whose policies interfere with investment growth. Political
risks include wars, changes in government leadership, and politically motivated
embargoes.
The 3 Types of Investment Risk

Definition

Risk associated with the unique circumstances of a particular company, as they might
affect the price of that company's securities.

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business risk
The risk that a business will experience a period of poor earnings and resultant failure.
Business risk is greatest for firms in cyclical or relatively new industries. Business risk
affects holders of stocks and bonds, since a firm may be unable to pay dividends and
interest.

Valuation Risk

Valuation Risk combines aspects of data management, financial engineering and

modelling and uncertainties related to the changing conditions of financial markets.

Force of Sale Risk

risk diversification

Definition

Allocation of proportional risk to all parties to a contract, usually through a risk premium.
Also called risk allocation. Diversification of risk means reduction of risk.
Seven major risks are present in varying degrees in different types of investments.

Default risk

Portfolio
This is the most frightening of all investment risks. The risk of non-payment refers to
both the principal and the interest. For all unsecured loans, e.g. loans based on
promissory notes, company deposits, etc., this risk is very high. Since there is no security
attached, you can do nothing except, of course, go to a court when there is a default in
refund of capital or payment of accrued interest.

Given the present circumstances of enormous delays in our legal systems, even if you do
go to court and even win the case, you will still be left wondering who ended up being
better off - you, the borrower, or your lawyer!

So, do look at the CRISIL / ICRA credit ratings for the company before you invest in
company deposits or debentures.

Business risk

The market value of your investment in equity shares depends upon the performance of

Measu
the company you invest in. If a company's business suffers and the company does not
perform well, the market value of your share can go down sharply.

This invariably happens in the case of shares of companies which hit the IPO market with
issues at high premiums when the economy is in a good condition and the stock markets
are bullish. Then if these companies could not deliver upon their promises, their share
prices fall drastically.

When you invest money in commercial, industrial and business enterprises, there is
always the possibility of failure of that business; and you may then get nothing, or very
little, on a pro-rata basis in case of the firm's bankruptcy.

A recent example of a banking company where investors were exposed to business risk
was of Global Trust Bank. Global Trust Bank, promoted by Ramesh Gelli, slipped into
serious problems towards the end of 2003 due to NPA-related issues.

However, the Reserve Bank of India's [ Get Quote ] decision to merge it with Oriental
Bank of Commerce [ Get Quote ] was timely. While this protected the interests of
stakeholders such as depositors, employees, creditors and borrowers was protected,
interests of investors, especially small investors were ignored and they lost their money.

The greatest risk of buying shares in many budding enterprises is the promoter himself,
who by overstretching or swindling may ruin the business.

Liquidity risk

Money has only a limited value if it is not readily available to you as and when you need
it. In financial jargon, the ready availability of money is called liquidity. An investment
should not only be safe and profitable, but also reasonably liquid.

An asset or investment is said to be liquid if it can be converted into cash quickly, and
with little loss in value. Liquidity risk refers to the possibility of the investor not being
able to realize its value when required. This may happen either because the security
cannot be sold in the market or prematurely terminated, or because the resultant loss in
value may be unrealistically high.

Current and savings accounts in a bank, National Savings Certificates, actively traded
equity shares and debentures, etc. are fairly liquid investments. In the case of a bank fixed
deposit, you can raise loans up to 75% to 90% of the value of the deposit; and to that
extent, it is a liquid investment.

Some banks offer attractive loan schemes against security of approved investments, like
selected company shares, debentures, National Savings Certificates, Units, etc. Such
options add to the liquidity of investments.
The relative liquidity of different investments is highlighted in Table 1.

Table 1
 Liquidity of Various Investments

Liquidity Some Examples

Very high Cash, gold, silver, savings and current
accounts in banks, G-Secs
High Fixed deposits with banks, shares of listed
companies that are actively traded, units,
mutual fund shares
Medium Fixed deposits with companies enjoying high
credit rating, debentures of good companies
that are actively traded
Low and very Deposits and debentures of loss-making and
low cash-strapped companies, inactively traded
shares, unlisted shares and debentures, real
estate
Don't, however, be under the impression that all listed shares and debentures are equally
liquid assets. Out of the 8,000-plus listed stocks, active trading is limited to only around
1,000 stocks. A-group shares are more liquid than B-group shares. The secondary market
for debentures is not very liquid in India. Several mutual funds are stuck with PSU stocks
and PSU bonds due to lack of liquidity.

Purchasing power risk, or inflation risk

Inflation means being broke with a lot of money in your pocket. When prices shoot up,
the purchasing power of your money goes down. Some economists consider inflation to
be a disguised tax.

Given the present rates of inflation, it may sound surprising but among developing
countries, India is often given good marks for effective management of inflation. The
average rate of inflation in India has been less than 8% p.a. during the last two decades.

However, the recent trend of rising inflation across the globe is posing serious challenge
to the governments and central banks. In India's case, inflation, in terms of the wholesale
prices, which remained benign during the last few years, began firming up from June
2006 onwards and topped double digits in the third week of June 2008. The skyrocketing
prices of crude oil in international markets as well as food items are now the two major
concerns facing the global economy, including India.
Ironically, relatively "safe" fixed income investments, such as bank deposits and small
savings instruments, etc., are more prone to ravages of inflation risk because rising prices
erode the purchasing power of your capital. "Riskier" investments such as equity shares
are more likely to preserve the value of your capital over the medium term.

Interest rate risk

In this deregulated era, interest rate fluctuation is a common phenomenon with its
consequent impact on investment values and yields. Interest rate risk affects fixed income
securities and refers to the risk of a change in the value of your investment as a result of
movement in interest rates.

Suppose you have invested in a security yielding 8 per cent p.a. for 3 years. If the interest
rates move up to 9 per cent one year down the line, a similar security can then be issued
only at 9 per cent. Due to the lower yield, the value of your security gets reduced.

Political risk

The government has extraordinary powers to affect the economy; it may introduce
legislation affecting some industries or companies in which you have invested, or it may
introduce legislation granting debt-relief to certain sections of society, fixing ceilings of
property, etc.

One government may go and another come with a totally different set of political and
economic ideologies. In the process, the fortunes of many industries and companies
undergo a drastic change. Change in government policies is one reason for political risk.

Whenever there is a threat of war, financial markets become panicky. Nervous selling
begins. Security prices plummet. In case a war actually breaks out, it often leads to sheer
pandemonium in the financial markets. Similarly, markets become hesitant whenever
elections are round the corner. The market prefers to wait and watch, rather than gamble
on poll predictions.

International political developments also have an impact on the domestic scene, what
with markets becoming globalized. This was amply demonstrated by the aftermath of
9/11 events in the USA and in the countdown to the Iraq war early in 2003. Through
increased world trade, India is likely to become much more prone to political events in its
trading partner-countries.

Market risk

Market risk is the risk of movement in security prices due to factors that affect the market
as a whole. Natural disasters can be one such factor. The most important of these factors
is the phase (bearish or bullish) the markets are going through. Stock markets and bond
markets are affected by rising and falling prices due to alternating bullish and bearish
periods: Thus:

• Bearish stock markets usually precede economic recessions.

• Bearish bond markets result generally from high market interest rates, which, in
turn, are pushed by high rates of inflation.
• Bullish stock markets are witnessed during economic recovery and boom periods.
• Bullish bond markets result from low interest rates and low rates of inflation.

How to manage risks

Not all the seven types of risks may be present at one time, in any single investment.
Secondly, many-a-times the various kinds of risks are interlinked. Thus, investment in a
company that faces high business risk automatically has a higher liquidity risk than a
similar investment in other companies with a lesser degree of business risk.

It is important to carefully assess the existence of each kind of risk, and its intensity in
whichever investment opportunity you may consider. However, let not the very presence
of risk paralyse you into inaction. Please remember that there is always some risk or the
other in every investment option; no risk, no gain!

What is important is to clearly grasp the nature and degree of risk present in a particular
case – and whether it is a risk you can afford to, and are willing to, take.

Success skill in managing your investments lies in achieving the right balance between
risks and returns. Where risk is high, returns can also be expected to be high, as may be
seen from Figure 1.
Figure 1: The Risk-Return Trade-Off

Once you understand the risks involved in different investments, you can choose your
comfort zone and stay there. That's the way to wealth.

(Excerpt from Personal Investment & Tax Planning Yearbook (FY 2008-09) by N. J.
Yasaswy, published by Vision Books.)

What are the components of the risk premium for investments?

The risk premium is the excess return above the risk-free rate that investors
require as compensation for the higher uncertainty associated with risky assets. The
five main risks that comprise the risk premium are business risk, financial risk,
liquidity risk, exchange-rate risk and country-specific risk. These five risk factors all
have the potential to harm returns and, therefore, require that investors are adequately
compensated for taking them on.

Business Risk
This is the risk associated with the uncertainty of a company's future cash flows,
which are affected by the operations of the company and the environment in which it
operates. It is the variation in cash flow from one period to another that causes greater
uncertainty and leads to the need for greater compensation for investors. For
example, companies that have a long history of stable cash flow require less
compensation for business risk than companies whose cash flows vary from one
quarter to the next, such as technology companies. The more volatile a company's
cash flow, the more it must compensate investors. (To learn more, see The Essentials
Of Cash Flow and Free Cash Flow: Free, But Not Always Easy.)

Financial Risk
This is the risk associated with the uncertainty of a company's ability to manage the
financing of its operations. Essentially, financial risk is the company's ability to pay
off its debt obligations. The more obligations a company has, the greater the financial
risk and the more compensation is needed for investors. Companies that are financed
with equity face no financial risk because they have no debt and, therefore, no debt
obligations. Companies take on debt to increase their financial leverage; using
outside money to finance operations is attractive because of its low cost. (For more
on this topic, see What do people mean when they say debt is a relatively cheaper
form of finance than equity?) The greater the financial leverage, the greater the
chance that the company will be unable to pay off its debts, leading to financial harm
for investors. The higher the financial leverage, the more compensation is required
for investors in the company. (To learn more, see When Companies Borrow
Money and Debt Reckoning.)

Liquidity Risk
This is the risk associated with the uncertainty of exiting an investment, both in terms
of timeliness and cost. The ability to exit an investment quickly and with minimal
cost greatly depends on the type of security being held. For example, it is very easy to
sell off blue chip stock because millions of shares are traded each day and there is a
minimal bid-ask spread. On the other hand, small cap stocks tend to trade only in the
thousands of shares and have bid-ask spreads that can be as high as 2%. The greater
the time it takes to exit a position and/or the higher the cost of selling out of the
position, the more compensation investors will require. (For more information, see
The Nitty-Gritty Of Executing A Trade.)

Exchange-Rate Risk
This is the risk associated with investments denominated in a currency other than the
domestic currency of the investor. For example, an American holding an investment
denominated in Canadian dollars is subject to exchange-rate risk. The greater the
historical amount of variation between the two currencies, the greater the amount of
compensation will be required by investors. Investments between currencies that are
pegged to one another have little to no exchange-rate risk, while currencies that tend
to fluctuate a lot require more compensation. (For further reading, check out Floating
And Fixed Exchange Rates.)

Country-Specific Risk
This is the risk associated with the political and economic uncertainty of the foreign
country in which an investment is made. These risks can include major policy
changes, overthrown governments, economic collapses and war. Countries such as
the United States and Canada are seen as having very low country-specific risk
because of their relatively stable nature. Other countries, such as Russia, are thought
to pose a greater risk to investors. The higher the country-specific risk, the greater the
compensation investors will require. (To learn more, see Investing Beyond Your
Borders and Determining Risk And