What is meant by the term “Risk”?

What is meant by the term “Risk”?

06 Nov 2019

Risk is an integral part of our life, something which is inevitable and which manifests itself in many ways. The world of investments is no exception to this basic rule. For an investor, 'risk' is the value of an investment that decreases due to a change in market factors. These factors will have an impact on the overall performance of the financial markets. Few risks can be reduced by diversification into assets that are not correlated with that particular market.

Risk can be divided into two broad categories - Systematic Risk and Unsystematic Risk.

Systematic Risk:

Market risk is also called as 'Systematic Risk". It tends to influence the entire market at the same time. Let us understand the different types of systematic risks and how to manage these risks better.

  • Currency Risk: It is also known as exchange rate risk. The risk that arises due to exchange rate fluctuations and affects returns on investment is called Currency Risk. Organizations with business operations in overseas markets are exposed to currency risks since their different financial results need to be consolidated into the company's home or domestic currency. Generally, a combination of forex forwards and options will allow the company to fix country risks within acceptable levels as long as premiums are reasonable.
  • Equity Risk: The risk that arises due to fluctuations in share prices is called Equity Risk. Prices can be volatile when witnessed either daily or over a shorter period. The inability of the underlying company to continue growing its business earnings and profits at a similar rate as before or at a higher rate is the real risk in equity investing. The value of the stock is likely to fall if this rate of growth of earnings or profits falls. Diversification in various sectors and asset classes can reduce equity risks.
  • Commodity Risk: Commodity risk refers to the uncertainties of future market values and of the size of future incomes, caused by fluctuations in the prices of commodities. For example, automobile manufacturers face commodity price risks because they use commodities like steel and rubber to produce cars. Major companies often hedge commodity price risks on futures and options contracts traded on regulated exchanges.
  • Inflation Risk:Inflation reduces the value of a currency's purchasing power. Bond payments are the most at inflationary risks because their payouts are generally based on fixed interest rates and an increase in inflation diminishes their purchasing power. Many financial instruments are available to counteract inflationary risks. To cite one example, Inflation-Indexed Bonds (IIB) provide the investor with constant returns, irrespective of the level of inflation in the economy. The main objective of Inflation-Indexed Bonds is to provide a hedge and safeguard the investor against macroeconomic risks in the economy.
  • Interest Rate Risk: This is the probability of a decline in the value of an asset resulting from unexpected fluctuations in interest rates. Interest rate risk is mostly associated with fixed-income assets. The interest rate is one of the primary drivers of a bond's price, and there is an inverse correlation between the interest rate and value of the bond. The interest rate risk is prevented by diversifying and hedging in different bonds.

Unsystematic Risk:

Unsystematic Risk, also known as specific risk or idiosyncratic risk, is a category of risk that only affects an industry or a particular company. Types of unsystematic risk include a new competitor in the marketplace with the potential to take a significant market share from the company invested in, regulatory changes (which could drive down company sales), a shift in management, or a product recall. It is commonly advised to diversify by investing in a range of industries or sectors to prevent this.

From the above, it is evident that there are indeed risks involved in market-linked investing. Investors have to deal with several risks in financial securities. Diversifying across securities and asset classes is one of the ways to reduce such risks. Diversification ensures that you still have others to help you keep your money goals intact even if one investment goes wrong. At the same time, adequate research on quality will ensure that performance and default risks are relatively fewer.

To put it in a nutshell, you cannot avoid risk. Instead of unduly directing your time and efforts on this aspect, viz., avoiding risks, it is better to be an informed investor by being mindful of the various types of risks that are involved and try to mitigate these risks in a systematic and disciplined manner.

The objective should be not to avoid or be fearful of risk but instead understand the types of risks involved and learn to navigate successfully through them.

Founded in 2005 by new–age entrepreneur Abhishek Bansal, the Abans Group has evolved into a globally diversified conglomerate, providing expertise in Broking Services, Non-Banking Financial Dealings, Financial Services, Agri-Commodity Services, Warehousing, Realty & Infrastructure, Gold Dore Refinery & Manufacturing, Trading in Metal Products, Pharmaceuticals, Software Development & Wealth Management. The Group is a comprehensive financial and non-financial services and solutions provider, aiming to provide end-to-end solutions to its clients.