The simplest (and yet the most powerful) definition of risk is the chance that an investment’s actual return will be different than the expected return (explained in detail here). The factors that drive this risk also help us categorise it into various buckets.
Throughout this article, we will use 3 different types of investment option to illustrate investment risks – shares of an automobile manufacturer (AM), bonds of an infrastructure company (IC), a house in suburbs of Mumbai purchased for investment purpose (RE).
While there are various types of investment risks, for the sake of simplicity, we will consider only 6 major types here. These stand to impact you, as an investor, the most:
Business risk is the measure of risk associated with business performance of the underlying investment instrument. Suppose you hold shares of AM worth Rs 10,000. Now if AM starts losing market share or has a strike in its factory which impacts production for 3 months, profits of AM will decline and will also have a negative impact on its share price. Your investment takes a hit and goes below Rs 10,000 due to poor business performance of AM. This is the business risk associated with holding shares of AM.
Credit risk or Default risk
Credit risk refers to the possibility that a particular bond issuer will not be able to make expected interest and/or principal payments. Suppose you hold bonds of IC and are entitled to annual coupon of Rs 1,000 and a principal repayment of Rs 10,000 after 5 years. If IC does not generate enough cash from its business, it is possible that it may default on its interest or principal obligation. Note that credit risk is also a type of business risk. Poor business performance leads to lower cash flow thus increasing the chances of a default.
We are all familiar with inflation (or at least we have all experienced it). Inflation means that general level of prices (of goods and services) is going up. Suppose you need to buy a motorbike, worth Rs 50,000 today, 1 year from now. You estimate that the price of the motorbike will rise by 7% in 1 year (inflation). You carefully invest Rs 50,000 cash in bank FD to earn you a post tax return of 8%. As it turns out, price of the motorbike increased by 10% and became Rs 55,000 while your FD matured to Rs 54,000. Not enough to buy that motorbike which you could have afforded a year ago! This is inflation risk – your investment returns falling short of actual inflation.
This is the risk that impacts your investments due to movements in the market as a whole. If the equity markets as a whole tanked (and a number of factors could cause this), your investments in shares of AM will also most likely take a beating. Notice the difference with Business risk where your investment was impacted due to business performance of AM. Your investment in bonds of IC could be impacted due to rising interest rates in the economy or your investment in RE could be impacted due to falling house prices. Factors driving market risk include domestic and global economic condition, Government policies, macro-economic policies and many more. The key thing to note here is that these impact the market as a whole and hence also impact the individual securities in that market.
Interest rate risk
Technically, interest rate risk is a type of Market risk but since it has such an important impact on fixed income instruments, we will treat it as a separate risk category. Without getting into too much complexities, let us understand one very important behaviour of fixed income securities – when interest rate rise, their prices falls and when interest rate falls, prices rise. This leaves fixed income instrument vulnerable to movement of interest rates in the economy. The degree of vulnerability depends on the type of fixed income security.
Let’s revisit our real estate investment (RE). Suppose you have purchased this house in suburbs of Mumbai purely from an investment perspective. Now after 4 years, you are in urgent need for cash and decide to sell the house. It is quite possible that you might not get a buyer immediately or even if you get one, he is not willing to buy at a price you think is the current market value of the house. You might just have to sit and wait till someone offers you the correct price. This is liquidity risk – inability to buy or sell an investment (a) as and when desired or (b) at a value that is reflective of the “fair” value.
So there you go! Now we understand investment risks and their major types and we also understand risk-return tradeoff. These are key to understanding the concept of asset classes (read here).