Risks in Investment

Risks in Investment

Investment is an integral part of portfolio management. It refers to the purchase of assets with the aim of generating income or profit in the future. However, there is always a certain amount of risk involved in investment. Risk can be defined as the likelihood of loss or failure of investment. Risk in investment is a complex concept that depends on various factors such as market conditions, economic trends, and individual investment strategies. In portfolio management, risk is managed through diversification, hedging, and asset allocation.

One of the primary risks associated with investment is market risk. This refers to the possibility of loss due to changes in market conditions such as interest rates, inflation, and exchange rates. These changes can negatively affect the value of the investment, resulting in losses for the investor. Market risk is unpredictable and can have a significant impact on the investment portfolio. Portfolio managers often mitigate market risk by diversifying investments across various asset classes and sectors.

Another risk in investment is credit risk. This refers to the risk of loss due to the failure of a borrower to repay a loan or debt. Credit risk is common in fixed income investments such as bonds and notes. Portfolio managers often manage credit risk by diversifying investments across various issuers and credit ratings.

Overall, risk is an integral part of investment and cannot be entirely eliminated. However, it can be managed through proper portfolio management techniques such as diversification, hedging, and asset allocation. Understanding the various types of risks associated with investment is crucial for portfolio managers to make informed investment decisions that align with their clients’ goals and risk tolerance.

In investment terminology, ‘risk’ refers to the variability of the expected returns. It is an attempt to quantify the probability of the actual return being different than the expected return. The variability of the return or the risk can be segregated into many components.

• Business Risk: This risk is the variability of returns introduced by the nature of business entity invested in. A change in the price of raw materials and finished goods, supply and demand for raw and finished materials, wage rates, fuel costs, economic lives of assets, tax laws, and changes in operating costs are some of the components pertaining to a business that have a direct impact on profitability or the ability to repay a business debt. Because of this the company’s share prices also get affected.
• Financial Risk: This is the variability of the returns from investments made in the company that is brought about by the financing mix used by the company. If only equity is used, its financial risk will be relatively less, as there will be no obligatory repayments to be made. A company using debt however will bear a bigger risk as there will be mandatory repayments of principal and interest. These factors lead to variable profits and share prices.
• Liquidity Risk: This is the uncertainty of the ability of an investor to exit from an investment when desired. Exiting an investment usually involves the secondary market where securities are traded. When assessing liquidity, one must take into consideration to points- time taken for liquidation and price realization. A security is illiquid when the investor either has to sell at a lower rate than expected or has to wait a long duration before disposing it or both.

 

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