1. Identifying the risks in investments

Identifying the risks in investments

Debt funds carry credit risks, interest rate risks and liquidity risks while markets volatility is the most important risk in equity investment

By: | Published: April 17, 2017 3:53 AM
Risk management in investments is the process of identify, analyse and mitigate the uncertainties in the investment decision.

Every investment is fraught with risks. Investors must analyse the risks in asset classes like debt and equity and find out ways to minimise them. Risk management in investments is the process of identify, analyse and mitigate the uncertainties in the investment decision.

Risks in fixed income

As investors are gradually looking at debt mutual funds as an alternative to bank fixed deposit, they should keep in mind that such funds from asset management companies have some risks. Debt funds have credit risks, interest rate risks and liquidity risks.

After investors invest in debt funds, the fund house collects all the money and invest in instruments like government bonds and corporate bonds. Government bonds have a sovereign guarantee and are even safer than bank fixed deposits. However, corporate debt paper carry very high credit risks.

Credit risk takes into account whether the bond issuer is able to make timely interest payments and pay the principal amount at the time of maturity of the bond. If the issuer is unable to do so, then the particular bond is likely to default. Bonds issued by state-owned companies like NTPC, ONGC, Coal India, etc., have high credit rating of AAA and carry a quasi-government guarantee. Investors should not invest in funds that have high exposure to companies having a large leverage.

Any change in the price of a bond because of changes in the interest rate can affect investors. Higher the maturity profile of the fund, more prone it is to interest rate risk. In case of increasing interest rate scenario, it will be positive for funds having a shorter maturity profile. On the other hand, a falling interest rate scenario will be beneficial for those funds which have a longer maturity profile. So, if you invest in debt funds of mutual funds, align investment horizon with that of a fund, which will help to mitigate the interest rate risk.

Investors should also look at liquidity risks of the funds, which means how quickly the fund manager can sell the particular paper in case of any downgrade. Corporate bond of high rated companies are more liquid than the lower rated paper. If the fund manager is selling the paper under pressure, then investors will suffer losses.

Fixed income investors also face reinvestment risks. If the interest rate falls and the bond matures, then the investor will not be able to reinvest the maturity amount for higher rates. Like equity funds, even debt funds are market-linked instruments and there is no assured returns or capital preservation.

Risks in equity investment

Markets volatility remains the most important risk in equity investment either directly or through mutual funds. It can impact investments if stock prices fall steeply or remain down for a long period of time. Ideally, to beat market volatility investors should invest via systematic investment plans (SIPs) of mutual funds. Investors must take note of the fund manager, his long-term track record, asset management company, its philosophy, fund expenses and investment style.

Equity investments also face industry specific risks and returns will suffer if the particular industry is going through a cyclical downturn. Brijesh Damodaran, managing partner of BellWether Advisors LLP says, an investor should find out about the risks involved instead of just worrying about the returns. “Our mindset is driven towards return and reward rather than risk and loss. And greed and fear is what finally determines your wealth or lack of wealth,” he says.

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