Types of Investment Risks & Navigating Them
In the world of investing, the pursuit of wealth comes hand in hand with the need for effective risk management. As investors navigate the complex wealth management world, they must realize that wealth preservation is as crucial as wealth accumulation. Every investment faces some risks that can potentially lead to financial losses or lower-than-expected returns on investments. Whether you choose to invest or not invest, you knowingly or unknowingly are taking risks. Identifying and understanding these risks becomes important for any investor so that one can effectively either avoid or reduce or take measures to manage the risks.
There are several key types of investment risks that investors should be aware of and this article aims to shed light on the types of investment risks faced by investors and the brief ways of managing these risks prudently.
Types of Investment Risks:
This is the risk emanating from overall market conditions and economic factors which can lead to the decline of investment value. We can extend this to risks related to changes in government policies, political instability, and regulatory shifts affecting investments. One can easily manage this risk with diversification at the asset class level and by having some understanding of the long-term market prospects given the conditions prevalent today.
The risk associated with changes in interest rates affecting the value of fixed-income or debt investments, like bonds. As interest rates rise, the value of debt investments fall and vice-versa depending on the maturity period of holdings. One can choose to diversify across different maturity levels and issuers to reduce this risk. Understanding interest rate cycles can also help us to manage this risk appropriately.
The risk that issuers or borrowers may default on interest payments or principal repayment, particularly relevant for bonds and loans. One can diversify across different issuers and credit ratings and choose to invest in highly rated instruments to reduce this risk.
The risk that investments may not be easily tradable at desirable prices, especially with less liquid assets. One can diversify into liquid assets and maintain an emergency fund for unexpected expenses to avoid selling illiquid assets in a hurry.
The risk that the purchasing power of investments may erode due to rising inflation. The best way to manage this risk is by investing in asset classes that give positive real, post-tax returns net of inflation. If you are only a debt investor, you can explore diversifying into other asset classes, especially equities, that have the potential for better real returns in the long term.
Risks associated with investing in a certain companies, sectors, or specific groups of companies including management issues, competition, supply chain disruptions, technology disruptions, etc. Such risks can be easily managed with diversification to reduce the impact of adverse events in a single company or group of companies.
Event risk relates to unexpected events that can impact investments, such as natural disasters, wars, or epidemics at the macro level or to personal life, health, and property at the micro level. In recent years, we have seen such risks globally and limited to specific countries. Again, the best way is to diversify, stay informed, and to also consider insuring yourself against any risks faced at the personal level.
This risk is associated with the uncertainty of how long you will live and whether your investments will last throughout your lifetime, especially when planning for retirement. The best way to manage this risk is to ensure that while planning, you factor this risk and create assets that will continue to grow and/or bring you lifelong cashflows. Also, ensure that you are appropriately covered by health insurance with high coverage.
Behavioral risk involves emotional factors influencing investment decisions. Quite often, we may make financial decisions based on biases and emotions. What we do becomes very critical over the long term and is something that will disproportionately impact our wealth in the long term, even when we do not realise this.
How to avoid and manage the risks:
The idea is to diversify and spread investments to reduce the impact of market and specific risks or risks of concentration limited to specific asset classes, companies, market capitalisation, sectors, etc. A proper diversified asset allocation is the starting point and then diversification with-in the asset class can help reduce the risk further.
As investors, we should have some degree of information and updates on the economic scenario and the prospects for equity and debt markets. Having a broad understanding and expected medium to long-term trends can help us manage our asset allocation and market risks, systematic risks, and interest rate risks better.
Evidence suggests that the market volatility or fluctuations tend to even out in the long run so by staying invested for the long term we tend to see more predictable and positive returns. This is why we say that for equities, we ideally have to only invest for the long term. A lot of systematic risks and market risks get settled/reduced in the long run.
Guidance and hand-holding by an expert goes a long way in managing risks is a much better way. The cost of learning, gaining experience, and opportunity costs for the initial years can be much higher and set you back by many years. Further, with expert guidance, we surely can expect one to avoid emotional and behavioural mistakes and help shape our investment approach, something which can greatly impact your long-term financial well-being.
Conclusion:
In the dynamic investment landscape of India, effective risk management is not a choice; it’s a necessity. Diversifying your portfolio, getting adequate insurance, and handling investment behavior are all vital components of a holistic risk management approach. With the guidance of seasoned experts and professionals like mutual fund distributors, you can have custom plans and a suitable investment portfolio to navigate the Indian market confidently as per your needs and risk profile. Happy investing!