Various types of Risks in Investments

A common definition used is 'Risk is the uncertainty that an investment will earn its expected rate of return.” It includes both Upside and Downside Risk. Although, we like the Upside Risk (return much greater than expected), we abhor the Downside risk. One needs to understand that both are sides of the same coin and mostly cannot be separated. If you want an instrument which can give / has given higher returns than expected in the past, then in future, the opposite can happen too.

There are plenty of places in which one can find the various types and details of various types of Risks. References:

I will just mention about the common ones from our perspective.

I. Inflation Risk or Purchasing-power Risk

This is probably one of the biggest “hidden” risk faced by us. I have made a small table which shows the official data of inflation (This is made by using Cost Inflation Index values in the last 30 years, which itself is calculated by multiplying 0.75 and the average consumer price index or CPI). Also, the rolling 5 year and 10 year inflation rates are also given. In my opinion, it would not be wrong to assume that even these values are smaller than the real inflation rates suffered by us, but then that is a separate discussion. Some main points, during the entire 90's, the average inflation was 10+%, while in 00's, it was moderate in the mid-00s and is again trending up.

What does this mean? In the simplest words, Inflation is a negative debt which is superimposed on all types of investment instruments. For under-the-mattress cash, a 10% inflation means, the value of Rs 100 becomes 90 in one year, in terms of real value, even though, the actual value is 100 only. Progressing this over 7 years, it will make the real value 48, while the nominal value will still remain 100.

Next, if you keep this in a savings account, then after one year, this value will become 104 (assuming 4% interest rate), but the real value will be 94 (in simple maths). After 7 years, it will have a real value of 65, but a nominal value of 128. This actually needs to be hammered in. Agents, advisors, media, etc show us the value of 128 and tell us how good that is, and how 'surely' you will get that nominal value (of course, there is least risk in a savings account), but in actual values, you have lost 35% of your purchasing power.

Higher up, you Save (invest is a wrong word there. Even GOI only tells us that we have a great savings rate of 30-32%, and not Investment Rate, so....) in a FD which presently is giving you 9% return. Amazing right. But if you see, the inflation rate is on an average 10%. So, even with 7 year FD, your real value will be 93, while the nominal value will be 145.

In short, the real return = nominal return – inflation. And this real return is what we should assume in our calculations. For long period of time, equities and real-estate tend to provide above-inflation returns. Whether this will hold for future, we do not know. But this is certain, most debt products and cash-equivalents (=the traditional risk free products) always lose in terms of real return.

II. Systematic Risk or Market Risk

This is an inherent risk of the asset class and cannot be removed by Diversification. This is the value which is mostly perceived by general public. FDs are safe = the systematic risk of loss of nominal value in FDs is very less. While Equities are not safe / risky = the systematic risk of loss of nominal value in equities is high. (Although, if 5-year and 7 year rolling returns are calculated, then FDs lose their real-return while equities score high in both real-return and nominal returns).

How to control Systematic Risk ? This can be controlled by using different assets which are not correlated with each other. So, when a portfolio is allocated across non-correlated assets, a systematic event may cause some assets to go down, while others may be unaffected, or even continue to grow.

III. Unsystematic risk

This risk is related to concentration in one stock or bond or company. Like buying a single stock exposes you to this kind of risk. This risk canbe managed by diversifying across different stocks or different bonds.

IV. Liquidity Risk

This is another “hidden” risk, which most people do not realise. Illiquidity means loss of flexibility. The costs of illiquidity are quiet. The extra yield seems free until there is a need for ready cash, whether to spend or to take advantage of investment bargains. There are all manner of illiquid investments offering yield, but almost all of them lock the investor up for a time. Prominent among them are all non-term insurances and FMPs. FDs have a built in illiquidity in the form of lower interest rate plus some penalty, in case of early withdrawal. Any product which guarantees you something will have high and/or long surrender charges.

Point to Remember: Never trust an insurance agent who is receiving a large commission to sell you an annuity. If they won’t disclose the commission, know that it is roughly the size of the initial surrender charge. Invariably all insurance policies never give the first year premium, in cases of early surrender.

“Don’t buy what someone wants to sell you. Buy what you have researched.”

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