Risks Involved in Investements
Risks in financial sector can be defined as the amount of uncertainty in the expectation of return for an investment made. To be precise, it can be said that when an investment is made, a certain return is expected out of it, and the deviation of the return of the investment from its expected return in the negative side; that is the actual return turning out to be lower than the expected return where the investor loses some of his money, this probability could be called the risk involved in any financial investment. The return of an investment is dependent on many key market factors and accordingly can be categorized into different types or versions of risk. The common fundamental about the risk factor in an investment is that greater the risk involved in it, the greater is its potential return, this can be accorded as, and the potential return to an investment is like the additional compensation for the amount of risk taken. The different kinds of risks involved are generally measured by the standard deviation of the historical or average return on the investment. Naturally, the greater the standard deviation the greater is the risk involved in the investment. In addition to this, there can be other factors which can be counted as risks in an investment, for example: If we have made an investment thinking that we could withdraw the fund anytime we want, but there is also a probability that in certain conditions and cases the fund may freeze depriving the investor to withdraw the fund at that time, this also can be accounted as a risk in the investment.
With an investment always come the common risks involved which is applicable to almost all the investment made and there are some specific risks which are attached to the time and type of the investment it is. An investment can be considered as wise if the investor understands the risk involved in it by analyzing all the factors which could affect the return of the investment. The investor should understand the types of risk involved in his investment according to the duration of the investment made and according to his own goals about the return he wants from it. When an investor understands the risk involved very well, he will be able to mange those risks using many financial tactics. The successful implementation of the right tactics at the right time efficiently enhances the return of an investment even if there is risk involved. Some of the common tactics used by the investors to manage risks could be choosing to invest in the right place according to their needs and investment timeframes, diversifying the investment total amount into smaller and different investments. Investment scams is also one of the risks involved.
In short, we can say that investment is never a risk free business, but with careful planning, right strategies and tactics, the risks can be managed to get higher and expected returns.
Having discussed how risk is always a part of an investment, let’s now talk about some of the common types of risks involved in investment.
Liability Risks/ Market Risks- Liability risks are the risks which happen due to a market crash or a prolonged bear market. This is not very rare that market conditions gets worse sometimes and take a long period to regain its original levels in which the investment was made. This kind of risk is also called natural risk because it is observed that every 10 to 15 years this has been occurring. When the market conditions remain down and take a long time to recover, it is called recession which is a very familiar term now due to its regular occurrence and its impacts on the economy of a particular region or sometimes even the whole world. Most of the time these recessions are preceded by high market valuation and advanced economic cycles. This kind of market conditions generally affects all kinds of portfolios in the market. The investors who have invested during the advanced business cycles and the high market valuations are the biggest losers here because the market slopes down and take a long time to reach its normal value, so anytime in between the withdrawal of the investment results in huge losses. A long term investors who tend to manage risks are not affected to a large extent in this kind of situation because the high market valuation before the recession results in gain and a wise investor would withdraw some investment to make some gains and to manage or compensate the risk he had taken during investing or the risk he is going to take by further investments. From an investor point of view, the investment should always a mix of high risk and low risk assets, also the investor should be able to plan ahead by assessing the market and value future markets. Also choosing the right portfolio to invest also plays a crucial role, sometimes it is wiser to hold back cash and wait for the right portfolio rather than just investing for returns without assessing the future market value. An investor with complicated portfolio holdings is expected to have a sophisticated strategy to get the market mix right. Stress testing is also a way to manage risks, here the investor tries to study the effect of an adverse market condition in future on the investment he is going to make and thereby gets to know the amount of market risk involved in the investment. If we try to further subdivide the market or liability risks according to the factors which could contribute to a bad market condition or a recession. They are described in brief below. Interest rate risks- There are always a possibility of losses due to movements in interest rate that the flow of money from assets and liabilities does not match. Equity and real estate risks- The movements of market values of equity and other assets like real estate where many capital investors make investments and this movement due to the decline in market value can result in losses. Currency risks- The risk involved in investment due to the movement of exchange rates. Different assets and liabilities are listed in different currencies and the movement in exchange rate can have an adverse effect on the return of an investment.
Credit Risks- Extending credit through investment and lending is a very important part and comprises quite a chunk of the business. The risks involved in such kind of investment are called the credit risk. Basically this risk is about the quality of the credit portfolio held by the insurer. Credit risk can be defined as the risk of financial loss occurring due to default or movement in the credit quality of issuers of security. Credit risk can be further categorized in the following ways. Default Risks- The risk bearded by the insurer of not receiving , delayed receiving or partial receiving of the cash or any other form of assets which is obliged to receive due to any kind of contract defaults in one or more obligation is called the default risk. Downgrade or mitigation risk- The risk that the future default value of the obligor will affect the present value of the contract in an adverse way due to any possible reason is called mitigation risks. Indirect credit or spread risk- Sometimes there is a market perception of increased risk in the market in either the microeconomic or macroeconomic scale, due to which the return on the investment decreases. This probability is called the spread risk. Concentration risk- There is a possibility that there could be increase in probability or exposure of losses for an investment due to high concentration of investment in a particular area, a particular economic sector or any other connected parties. This decreases the value of the assets which subjects to decrease in investment returns and is called the concentration risk in an investment.
Liquidity Risks- Liquidity risks is the risk that at a particular juncture there could be a possibility that the obligated party will not be having sufficient liquid assets to meet his/her obligation. The obligated part may have sufficient assets with him but when these assets are not liquid assets which could be used ti meet the immediate obligation of payments like claims or policy redemption fees, only this situation comes under the liquidity risks in an investment. Liquidity risks as a whole can be classified into the following sub parts. They are-
Liquidation value risks- An unexpected requirement of money may force the investor to liquidate the assets he has and the unfavorable market condition prevailing could decrease the potential value of the asset resulting in financial losses. This type of risk is known as liquidation value risk. Affiliated investment risks- Sometimes an affiliated member company in a conglomerate is difficult to sell that is the asset is very difficult to liquidate which creates a drain of financial and operating resources from the insurer. This type of risk is called the affiliated investment risks. Capital Funding Risks- Due to the absence of sufficient liquid assets with it , an insurer does not get the required or desired amount of outside funding at the time when it needs which can again go on to result in huge financial losses , this type of risk involved is called the capital funding risks. One very common example of this kind of risk occurs when there is a huge claim or a surrender amount where the insurer is not able to pay because of the absence f the required assets in liquid form like in an event of an earthquake or any other natural resources there is mass destruction and an property insurance company which had made a significant investment in insuring the houses in a particular area , this event will trigger the requirement to pay the claims of the damaged insured property within the stipulated time and as this amount could be very large the insurance company may face difficulties to liquidate its assets and pay which will result in paying fines or other penalty due to not being able to pay the claims which eventually is a financial loss.
There are two prominent ways in which the liquidity risk can be managed. They are day to day cash management and testing and scenario analysis which also includes the analysis of a catastrophe event. Measurement of insurer’s exposure to risks and cash flow management and analysis of financial ratios can also help in management of liquidity ratio.
In addition to the above mentioned risks the most common risk involved in any kind of investment is the volatility risks. This risk is about the risk which any investor would take of the probability of future decrease in market value of investment or financial loss due to the volatility of market. In other words volatility risk can be called as a consolidated risk of many different types of risks which cumulatively move the market index and make the market volatile which in the chain results in the value of the investment made in that market.
Basically, if we sum of the risk involved in investment it is basically about the uncertainty in the movements of market value of the assets or investment made. It is for sure to make the exact strategy and completely manage the risk but a calculated risk with sufficient risk can be effective. It is also important the information regarding the volatility of the portfolio also be backed up by an asset allocation profile and a valuation analysis, to give a full assessment of current risks and how aggressive or conservative the underlying strategy actually is. The risk assessment process should be primarily an education process and an opportunity for the investor to make adjustments to the recommended portfolio that more closely mirrors their risk preferences. But this cannot be done without the expertise of the advisor in assessing risk preferences.
There is also a risk called the positive investment risk. This is where an investor could justify his investment portfolio with future market valuation forecasts by right analysis and then having a return plan based on a correct investment strategy.
-Prateesh and Nabakishore