A guide to understanding 7 different investment risks

Although investing is a great instrument for building money, investors have to account for the different types of risk in investment. The kinds of risk present in stock markets and other investment vehicles can greatly affect returns.

Investors must fully comprehend these risks since they impact various asset classes and investment strategies in different ways. However, though they cannot be totally avoided, they can most certainly be reduced.

The article will thoroughly review the different types of risk in the stock market and how these risks affect different asset classes and management methods.

What are the 7 Types of Risks in Investment?

Investing involves various risks that affect returns and overall financial stability. Thus, understanding the different types of investment risks is crucial for making informed financial decisions and developing a robust investment strategy.

Here are the seven key types of risks to consider:

1. Market Risk

Market risk refers to the possibility of losing money due to market fluctuations. Factors like economic downturns, geopolitics, shifting investor moods, and natural calamities increase market risk. Though it can impact bonds, commodities, and other asset classes, this risk primarily affects stock investments.

How Market Risk Affects Different Asset Classes

Stocks: Equity markets are very susceptible to market risk, which could lead to significant price volatility. The S&P BSE Sensex Index in India experienced a nearly 37.01% decline in the first quarter of 2020, underscoring the vulnerability of stocks to sudden market declines at the onset of the epidemic.
Bonds: Bonds are sometimes considered safer investments, but they are not free from market risk—more on that later—especially in light of changing interest rates.
Commodities: Changes in supply and demand, geopolitical uncertainty, or weather can all affect the price of commodities.

Tips to Mitigate Market Risk

Consider the following strategies to reduce market risk:

Diversification: Spread your investments over locations, sectors, and asset classes to reduce the whole influence of market downturns.
Long-term Perspective: In the long run, investing time in the market typically yields greater returns than attempting to time the market. The extended length of diverse portfolio holdings helps to reduce short-term volatility.
Hedging: Hedge against market swings via financial tools, including futures and options.

2. Credit Risk

Credit risk is the possibility that a borrower will default on their obligations, leading to financial loss for the lender. This risk is especially relevant to fixed-income investments like bonds, corporate debt, and loans.

How Credit Risk Affects Different Asset Classes

Corporate Bonds: Investing in corporate bonds always carries a risk that the issuing company will fail to pay back the principle amount or default on interest payments. The annual default rate for corporate bonds in India for the fiscal year 2022 was 2.2%, according to CRISIL, which was far lower than the 4.1% average over the last decade.
Loans: Credit risk is particularly important in the peer-to-peer lending market because loans can be unsecured. As a result, platforms and investors must carefully evaluate borrower creditworthiness.

Tips to Mitigate Credit Risk

Consider the following strategies to reduce credit risk:

Credit Ratings: Select investments with strong credit ratings from reputable companies like CRISIL and ICRA. This lowers the default likelihood.
Diversify Across Credit Profiles: Steer clear of focussing investments in a small number of issuers or high-yield onds. Sort your investments among several credit levels.
Monitoring and Due Diligence: Regularly review the financial health of issuers to stay ahead of potential defaults.

3. Liquidity Risk

Liquidity risk occurs when an investor is unable to sell their assets quickly enough without influencing the asset’s price. Less liquid markets, such as real estate, small-cap equities, or specialist investment products, highlight this risk more clearly.

How Liquidity Risk Affects Different Asset Classes

Real Estate: Real estate is among the most illiquid asset sectors; selling it without significantly lowering the price may take months, if not years.
Small-Cap Stocks: During erratic times, small-cap equities are difficult to buy or sell at market prices because, in the stock market, they often have less liquidity than large-cap stocks.
Mutual Funds: Certain kinds of mutual funds, especially those that invest in small-cap companies or speciality sectors, could also have limited liquidity.

Tips to Mitigate Liquidity Risk

Maintain a Cash Reserve: To cover temporary financial needs, always keep some of your portfolio in highly liquid assets, such as cash or liquid mutual funds.
Understand Market Liquidity: Before making investments, review the asset class’s liquidity. Equity mutual funds, for instance, that invest in large-cap companies are often more liquid than those targeted at small-caps.
Staggered Exits: If selling a lot of shares, investors should think about selling in tranches to minimise a notable price impact.

4. Interest Rate Risk

Interest rate risk is the possibility that variations in interest rates will cause the value of an investment to drop. This risk typically impacts fixed-income products such as bonds.

How Interest Rate Risk Affects Different Asset Classes

Bonds: Bond prices have an inverse link to interest rates. Bond rates drop as interest rates rise, and vice versa.
Fixed Deposits (FDs): The interest rates on FDs provided by large Indian banks have also changed over the past two years. Higher rates can reduce the value of currently owned bonds, even while new FDs gain popularity.

Tips to Mitigate Interest Rate Risk

Consider the following strategies to mitigate interest rate risk:

Bond Laddering: Sort your investments among bonds with varying maturities. This ensures that rate changes at any given moment do not expose you to too much.
Floating Rate Bonds: Consider investing in floating rate bonds whose coupon payments adjust with prevailing interest rates, reducing the impact of rate hikes.
Shorter Duration Bonds: When rates are predicted to climb, shorter-term bonds—which are less vulnerable to interest rate fluctuations—are a safer choice.

5. Inflation Risk: Eroding Purchasing Power

Inflation risk refers to the potential for rising prices to diminish the purchasing power of returns. This risk affects practically all types of investments, but fixed-return investments suffer the most.

How Inflation Risk Affects Different Asset Classes

Bonds: Because the real value of interest payments erodes over time, fixed-rate bonds are particularly vulnerable to inflation.
Real Estate: Real estate is sometimes used as a hedge against inflation because rental income and property values typically rise with inflation.
Equities: While stocks usually provide stronger defence against inflation than fixed-income assets, they are not totally immune, particularly if inflationary pressures cause rising interest rates.

Tips to Mitigate Inflation Risk

Consider the following strategies to mitigate inflation risk:

Inflation-Linked Bonds: Investing in government-issued inflation-indexed bonds, whose yields rise with inflation, could help.
Equities: A diversified portfolio may yield a long-term gain faster than inflation.
Real Assets: Real assets, such as commodities and real estate, sometimes retain their value in inflationary times.

6. Currency Risk: A Challenge for International Investments

Currency risk, also known as exchange rate risk, affects investors holding assets in foreign currencies. This risk is common when the value of a foreign currency swings in relation to the investor’s native currency.

How Currency Risk Affects Different Asset Classes

Foreign Stocks and Bonds: Investors in overseas equities or bonds run the risk of having gains wiped out by negative currency swings.
Foreign Mutual Funds: Variations in currencies also affect mutual funds allocated to overseas markets.

Tips to Mitigate Currency Risk

Consider the following strategies to mitigate currency risk:

Hedged Investments: Choose ETFs or mutual funds that balance currency risk.
Diversify Across Currencies: Distribute your investments among several foreign currencies to help to offset the effect of a devaluation of one currency.

7. Regulatory Risk: Changing Laws and Regulations

Regulatory risk is the likelihood that changes in government policies, laws, or rules can compromise an investment. Changes in tax laws, banking rules, or sector-specific policies (such as those controlling real estate or telecommunications) might generate regulatory risk in India.

How Regulatory Risk Affects Different Asset Classes

Telecommunications: Regulatory changes can significantly affect industries such as telecoms, potentially impacting profitability.
Real Estate: Changes in property regulations, such as the Real Estate (Regulation and Development) Act (RERA), have transformed the sector in India.
Taxation: New tax rules, such as those proposed in the Union Budget, have an impact on investment returns.

Tips to Mitigate Regulatory Risk

Consider the following strategies to mitigate regulatory risk:

Stay Informed: Stay up-to-date on laws that can impact your investments.
Sector Diversification: Spread your money across several sectors to reduce your exposure to the regulatory risks of any one sector.

Conclusion

Understanding the types of risk in investment is only the first step in developing a sound investment strategy. While risks cannot be completely eliminated, they can be effectively managed through several methods that ensure more stability and long-term growth.

A balanced portfolio is crucial for spreading risk across various asset classes. Diversification helps to cushion losses in one area by offsetting them with gains in another. For example, combining equities, which are more volatile, with bonds, which are relatively safer, can mitigate market and credit risks. Each asset class reacts differently to market conditions—bonds tend to perform better in downturns while equities often lead in bull markets. This balance between risk and reward is key to minimising the potential negative impacts of various risks.

The information provided here is for informational purposes only. PowerUp is not responsible for any errors, omissions, or outcomes related to the use of this information. Always consult with a financial advisor before making any investment decisions.

FAQs

1. What are the main types of risk in investment?

The main types of investment risk include market risk, credit risk, liquidity risk, interest rate risk, inflation risk, currency risk, and regulatory risk. Each risk affects different asset classes in unique ways, making it essential for investors to understand how these risks could impact their portfolios.

2. How can I mitigate market risk in my investment portfolio?

Diversification, long-term view, and use of hedging techniques such as options and futures help reduce market risk.

3. What are the types of risk in stock market investments?

In stock market investments, market risk, liquidity risk, and occasionally currency risk—should one be investing in foreign stocks—are the main forms of risk. External events, including geopolitical developments and economic changes, expose equity investors, especially to volatility.

4. How does inflation risk impact fixed-income securities?

Inflation risk reduces the purchasing power of the fixed returns from securities like bonds. Investing in inflation-linked bonds or equity can help counterbalance this risk.