Three Risks that can harm your Profits

Three Risks that can harm your Profits

17 Sep 2018

Risk is an integral, inevitable and unavoidable part of the investing process. In reality, risk comes in various forms and this in turn affects the performance of your portfolio. Identifying, recognizing and understanding risks are the key to effective management of risks in your portfolio.

Following are the three basic risks that affect an equity and debt investor:

1. Inflation Risk –

Inflation risk, also called purchasing power risk, is the probability that the cash flows from an investment won't be worth as much in the future on account of changes in purchasing power due to inflation.

For example, Rs. 1,000,000 invested in bonds with a 10% coupon rate might generate enough interest payments for a retiree to live on, but with an annual 3% inflation rate, every Rs. 1,000 produced by the portfolio will only be worth Rs. 970 next year and about Rs. 940 the year after that. The rising inflation means that the interest payments have less and less purchasing power. Further, the principal, when it is repaid after several years, will buy substantially less than it did when the investor first purchased the bonds.

The investments of investors in fixed income securities may not earn enough to keep up with the prevailing inflation rates. You need to adopt an aggressive stance in order to help adequately mitigate the risks that inflation introduces to a portfolio. The crucial thing is how you position your portfolio to fight inflation. Every investor must have some equity exposure in their portfolio and it is equity that helps create wealth, with a reasonable probability of generating returns which can beat inflation.

It is important to note that inflation risk isn't the risk that there will be inflation; it is the risk that inflation will be higher than expected. This is one reason investors and analysts speculate considerably about inflation rates and study indicators such as the yield curve to get a feel for where inflation rates are headed.

Some friendly tips on how to manage Inflation risk –

a. Avoid a High Concentration of Long-Term Bonds in Your Portfolio

b. Own Investments That Can Increase Cash Flows

2. Valuation Risk –

The key investment risk faced by equity investors is the risk that you overpay for an asset. The best time to be buying is when prices are cheap relative to the underlying value of the company. Investors must recognize periods wherein assets are rather undervalued and seek opportunities to take advantage of those. The danger of investing in companies that appear overvalued is that there is normally little room for error. The business may indeed be wonderful, but if it experiences a significant sales decline in one quarter or does not open new locations as rapidly as it originally projected, the stock will decline significantly or, alternatively, tread water for years as the excess valuation is burned off. This is a throw-back to our basic principle that an investor should never ask "Is company ABC a good investment?”; instead, he should ask, "Is company ABC a good investment at this price?"

Some friendly tips on how to manage Valuation risk –

a. Rebalance the portfolio on earning growth and relative performance. Companies that grow their profits see their weight increased.

b. Increase weight to stocks that have fallen in price despite exhibiting positive earnings growth.

c. Reduce most expensive quartile and stocks with negative earnings.

Therefore, instead of just following mutual fund investment tips given by your friends and relatives, or acting upon hearsay or mere opinions, you need to check some basic things before investing in a mutual fund. The following points would assist you in selecting the most appropriate fund for your specific requirements:-

3. Interest Rate Risk –

Fixed income investors take the risk of a rise in interest rates after they buy the bond or invest in a fixed deposit. Rising rates are very much of a lifesaver for fixed income investors whose investments are tied to interest rates and bad for people with debt.

For example, let’s assume you purchase a bond from Company XYZ. Because bond prices typically fall when interest rates rise, an unexpected increase in interest rates means that your investment could suddenly lose value. If you expect to sell the bond before it matures, this could mean you end up selling the bond for less than you paid for it (a capital loss). Of course, the magnitude of change in the bond price is also affected by the maturity, coupon rate, its ability to be called, and other characteristics of the bond. One common way to measure a bond's interest rate risk is to calculate its duration.

Some friendly tips on how to manage Interest rate risk-

a. It would be wise to lock the fixed income allocation of your portfolio in long term debt funds or fixed deposits if interest rates are slated to fall.

b. It would not be wise to lock in your money at lower rates if interest rates are slated to rise.

Empirical evidence suggests that wealth creation is achieved through investing in debt or equity over longer periods of time. And investing is not a rocket science ; it would certainly need a bit of understanding about the businesses (companies) that one chooses to invest in, to analyze the macro-level environment and the sector of the company, etc. Undoubtedly, direct equity investing saps up a lot of energy in trying to identify the right stock, keeping a tab on that while the success is limited. Without proper guidance or research, one may encounter failures or investment losses due to wrong investment decisions and judgement. The aforesaid points will guide an investor as to how to take care of his / her investment needs and how not to lose money on risk of inflation, valuation and interest rate risk of his / her portfolio.

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