You now have a fair idea of the different types of return. It’s time to understand the different types of risk because return and risk are the two sides of the same investment coin. Remember, if you want to earn more return you will have to take more risk.
Risk refers to the possibility that the actual returns are different from the anticipated returns. That way, the actual return may turn out to be greater than expected return or less than expected return. The former is referred to as upside risk and the latter as downside risk. While downside risk hurts more, both are relevant.
Scroll on to the five types of risk relevant to investments.
Inflation Risk: Inflation refers to the rise in the price of products and the consequent fall in the value of money. Suppose the price of a product today is Rs 100.
Suppose a year later its price is Rs 108. We say that the price of the product has increased by 8 per cent, or better still, that the product has suffered an inflation of 8 per cent. Since different products can suffer different rates of inflation, it makes sense to have inflation reckoned for a basket of products. Enter whole sale price index and its rise.
Every investment must cover the inflation risk: An error in judgment can leave you short changed. Suppose you invest in a fixed deposit that pays you 8 per cent per annum.
If the expected inflation is 5 per cent, the real rate of return is 3 per cent. This is because while the Rs 100 grows to Rs 108, the price of the product will move from Rs 100 to Rs 105 by that time. So, a year later, you are richer by only Rs 3. Now if the inflation unexpectedly climbs to 7 per cent, your real rate is 1 per cent. Today, with inflation close to 12 per cent, bank deposits are giving you negative return.
Interest Rate Risk: Interest rates don’t stay static; they move up and down unannounced. Interest rate risk refers to the impact that rising interest rates have on bond values. When interest rates go up, the value of an existing bond comes down. And when interest rates fall, the value of the existing bond goes up. Suppose a company has issued a bond (First Series) with a face value of Rs 100 and a coupon rate of 8 per cent. Say, its current market price is Rs 100. Now, suppose the company issues a Second Series at a coupon rate of 11 per cent. What would you, an investor in the First Series, do? Surely you would sell your First Series and buy the Second Series. But then who will buy from you — after all everyone is as smart as you are! Surely no one would want to get Rs 8 on an investment of Rs 100 when they can get Rs 11.
This is what will now happen in the market. The price of the First Series will quickly fall down to a level which gives a return of 11 per cent; namely, Rs 72.
So a rise in interest rates leads to a fall in the value of the existing bond. Of-course, if, conversely, the interest rates fall, the market value of the bond will go up. In essence, bond value and interest rates move in opposite directions.
Default Risk: This refers to the possibility that not only is the promised rate of return not paid, but that the principal amount invested too could be lost. Default risk is highest in the case of investment in companies that have speculative grading, companies that are run by first generation entrepreneurs and companies that offer unbelievably high rates of return.
Any investment that offers you significantly higher rate has to be taken with a pinch of salt. For instance, if corporate fixed deposits generally offer you 11 per cent and a particular company offers you 20 per cent, your risk antenna should be up.
Liquidity risk: Liquidity refers to the speed with which an investment is convertible into cash without significant loss of value. Cash is the most liquid asset. Next come government bonds. Incidentally, stocks too suffer liquidity risk.
Like, when a security that you hold has to be sold in the market place at a price that is substantially less than its fair value, you are said to suffer liquidity risk. House property has a huge liquidity risk. You cannot sell it in a hurry. You have to wait to get the right price.
Reinvestment Risk: An investment gives return in the course of its life. For example, fixed deposits pay interest. Stocks pay dividend. So do mutual funds. In arriving at the return from these investments we assume that the intervening cash flows (interest, dividend etc) are re-invested at the same rate. If they cannot be re-invested at the same rate but have to be re-invested at lower rates then the investment is said to suffer re-investment rate risk.
It is, therefore, sometimes good to not receive intervening cash flows because the risk of reinvestment gets thrust on you. All these risks do not reside in every investment or affect every investment in like manner. Most importantly, how do you compute these risks and assign a value?
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