What is Risk and Why Does it Matter?

In the previous chapter, we discussed savings and investing. We rounded up with a small hint on ‘risk.’ So, you are probably thinking about what risk in investment is all about.

Have you ever planned a journey and suddenly found yourself stuck in terrible traffic or ran out of fuel? This is basically how risk works in the financial world. It is those surprises or roadblocks during your course to building wealth through investment. It is similar to finding the road blocked when you thought it was clear – perhaps a dive in the share prices or an investment that didn’t pan out as well as you initially expected.

But here's the thing: unexpected delays and frustrations are not consistent. You can be aware of these potential pits, which is similar to having a good GPS in your car. It guides you around some of those bottlenecks or at least gives you a heads-up and prepares you for them. 

With that, let’s dive deeper into the world of risks in investment, understand what are risks, why do they matter, and what exactly is risk tolerance! 

What is Risk?

Risk is the variability associated with the returns that you anticipate receiving from your investments. It is the risk of misperformance whereby investments may not perform as expected, and, in extreme cases, you might lose some or all capital invested. Imagine it as a journey for treasure where the treasure you capture is your investment return. Sometimes, you end up following the map and get to your destination, but other times, you might get off track.

Broadly, risk can be categorised into the following two types: 

• Systematic (Market) Risk: This is like a hurricane that covers the entire ocean on which you sail your ship, packed with investments. It encompasses large-scale events such as economic recession, political turmoil or a global pandemic. These factors have the power to shape inflation rates, interest rates and exchange rates that eventually affect entire markets or sectors of business operations.
• Unsystematic Risk: This is more similar to encountering an unforeseen obstacle specific to the chosen path or road towards your destination. It is the specific risk that a particular company or industry faces. These incidences include financial instability that a company faces or a sudden change in consumer preferences that affect one product or service.

It is worth noting that this classification is extremely broad, and in the ensuing sections of this chapter, we will discuss some of the specific types of risks. As of now, let us try to understand why risk is important.

Why Risk Matters?

Consider that you are preparing for a big future endeavour – such as purchasing a home or saving to pay for your retirement. You need to understand what level of rough seas you might encounter on your travels so you can pick the appropriate ship (investment) and security equipment (risk management solutions).

Take, for instance, Emily, a young and ambitious 30-year-old who takes the plunge and invests her hard-earned money in a rising tech startup. She is well aware of the risks involved, yet her determination to enter the ever-evolving and fiercely competitive tech industry drives her forward. However, she also realises that if the start-up succeeds, her returns may be great. It is this high-return potential that draws Emily to accept the higher risk.

On the other hand, risk matters not just because of its potential gains but also on how much one can lose. What if the said startup where Emily put all her money fails? Well, she will lose all she invested.

Types of Investment Risk

Now, let’s go into the different types of risks you may face in the investment world. Consider these as the various weather systems you may encounter on a sailing journey – each with its own obstacles and specific methods of handling.

Market Risk

Market risk, also referred to as systematic risk, is a category of investment risk that affects the whole market or an entire asset class. This is an unavoidable risk for the whole market, and as such, it cannot be eliminated or minimised by diversification. It is related to broader economic, political or global events that affect the entire financial market.

To illustrate this concept, let us examine the global financial crisis of 2008. During this tumultuous period, the BSE SENSEX experienced a sharp decline of over 60% from its peak in January 2008 to its lowest point in March 2009. As a result, an investor's initial holding of ₹1,00,000 in a SENSEX-tracking fund could have significantly reduced to around ₹40,000. 

The significance of understanding market risk cannot be stressed enough, as it affects all investors regardless of their securities. It is essential to acknowledge that market risk cannot be eliminated through diversification, making it a crucial factor to consider when planning for long-term investments.

Credit Risk

Credit Risk, also referred to as default risk, is a non-systematic risk associated with the probability of default on loans. This risk is especially applicable to debt instruments such as bonds.

Let’s take a hypothetical scenario involving bonds to understand credit risk:

• Just assume that you put in ₹1,00,00 in the bonds of a financially sound company with good credit. Suppose that these bonds pay an annual interest rate (coupon rate) of 8%.
• Now, if the company finds itself in a financial crisis due to unpredictable market conditions or poor management, there is an increasing probability of default on the bond payment by this company.
• In case the company defaults, you may not receive the annual interest payments and also, there is a threat of loss on the maturity amount. In the worst-case scenario, if the parent company files for insolvency, you might end up losing much or even all of your ₹1,00,00 investment.

Credit risk is relevant as it directly determines your return on investments made in debt instruments. Unlike equity investments in which the risk is priced into the stock prices, debt securities such as bonds are subject to sudden valuation changes due to credit risk events.

Liquidity Risk

Liquidity Risk describes the possible inability to sell or buy an asset without influencing its price significantly. In contrast to market or credit risk, liquidity risk is specifically investment-level and widely differs from one asset type to another.

The beginning of the COVID-19 pandemic witnessed a crash in stocks, which is an example of liquidity risk. Many investors who were trying to get rid of their holdings in comparatively illiquid assets, such as few mutual funds and small-cap stocks, suffered greatly because of the price collapse arising from the abrupt influx.

Liquidity risk is highly important because it may significantly impact your ability to get money when you need it the most. This is especially important for investors who may be forced to quickly sell assets due to unplanned factors.

Inflation Risk

Inflation Risk refers to the probability that increasing inflation will reduce the yield on investment, thus eroding purchasing power over time. This type of risk should be considered even more so when thinking about long-term investments.

Imagine this scenario: You decide to make a smart investment of ₹1,00,000 in a fixed deposit with an attractive annual interest rate of 5%. With anticipation, you eagerly wait for a year to see your investment grow to ₹1,05,000. However, life is not that simple. Just as you think your money has increased, the harsh reality hits you. Inflation, which is currently at 7%, has eaten away your hard-earned ₹1,05,000, leaving you with much less purchasing power than you had initially expected. 

This is the danger of inflation risk, especially when it comes to conservative investments like fixed deposits or bonds. Such investments may not always keep up with inflation, resulting in a reduction in the real value of your money. Neglecting to consider inflation risk can lead to an insufficient amount of funds for long-term purposes.

Concentration Risk

Concentration Risk refers to the risks involved in concentrating large shares on a single investment, asset class or market sector. It’s a question of putting all the eggs in one basket.

Picture you investing ₹5,00,00 in the stock of a single company. If the company is outstanding, your investment may grow significantly. On the other hand, if there is a company downfall or some industry-related issues, your loss will be high. For instance, if shares drop by 50% due to a scandal or bad earnings, then your investment of ₹5 lakh becomes half that is ₹2,50,000.

Concentration risk is essential, as it can cause substantial losses if the specific investment or sector you are investing heavily into does poorly. The risk is especially high for investors who may be excessively bullish on a particular company or sector.

As we proceed to Risk Tolerance and consider some of the investment strategies for dealing with such risks, it should first be pointed out that the risk categories mentioned above are not exhaustive.

There are various risks as well that we haven’t touched upon in this list. Nevertheless, this discussion should serve well enough to get you started with understanding financial risks and their various forms.

Risk Tolerance

Think about riding a roller coaster. The high drop-offs and speeds excite some people while others would rather enjoy a relaxed ride around the park. This contrast in tolerance for swings is what we call ‘risk tolerance’ in the investment realm.

Risk tolerance is, in fact, the amount of risk that you are willing to take in your investments. It is an individual characteristic and differs significantly from one person to another. Think of it as your financial safety zone.

Why Knowing Your Risk Tolerance is Important?

Knowing your risk tolerance is like knowing how much to bet in a game that has high stakes. Very simply put, it can help you:

• Make smarter and more informed investment choices. 
• Avoid emotionally charged financial decision-making. 
• Achieve financial goals more smoothly and in a calculated manner. 

Here’s how you can quickly start thinking about risk tolerance, and maybe figure out how risk tolerant you are:

• High-Risk Tolerance: A 30-year-old software engineer, Raj, with a secured job and no dependants, may have a high-risk appetite where he can heavily invest in stocks or other investments. He is comfortable with high volatility for the potential of good returns.
• Low-Risk Tolerance: A 55-year-old woman near retirement, Anita prefers parking her savings in fixed deposits and bonds. She wishes to remain within her capital, but she cannot afford large changes in the value of her investments.
• Moderate Risk Tolerance: Vikram, who has a family and is 40 years old, may mix it up. His portfolio is a combination of stocks and bonds. He can handle some of the peaks and valleys but not too many.

In this chapter, we have traversed the different types of investment risks and their impact on your financial journey. Knowing about these risks is similar to learning how to read a weather map before boarding the ship – it serves as an important step toward a successful trip.

But what's next? In the world of investments, there is always a silver lining to every cloud. As much as there are risks involved, there is also the potential for greater rewards. And this brings us to our next topic which is based on the intriguing connection between risks and returns!