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Investment planning: Five investment risks you need to factor in

Irrespective of how diversified your investment portfolio is, there are always multiple investment risks in play.

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As an investor, it is always recommended to understand the investment risks involved before taking any decision.

By Hemanth Gorur

Investment risk is reduced by putting your investments into different assets like gold, property, bonds and stocks. Having a portfolio of investments spreads your risk across investments that react differently to market forces, thus reducing your investment risk.

Yet, investment risk does not get completely negated. Irrespective of how diversified your portfolio is, there are always multiple investment risks in play. Let us see what are these investment risks.

Inflation risk

This is the most fundamental risk that all investors are exposed to. Inflation represents the loss of your money’s purchasing power ie., the rate at which your money loses value over time. So, when you invest, your investment needs to beat at least the inflation rate in order to avoid a loss on the principal invested. Normally, safer investments like bonds, fixed deposits, Government Securities (G-Secs), or Treasury Bills (T-Bills) yield lower returns, so they may or may not be able to beat inflation. In contrast, large cap stocks, mutual funds, and gold are generally able to beat inflation in the long term.

Interest rate risk

This risk represents the risk that your investment’s value will change due to a change in the interest rates in the market. Debt instruments like bonds and debentures are directly affected by any movement in interest rates since their prices move inversely in relation to interest rate movements— bond prices fall if interest rates rise and vice versa. With equity instruments like stocks or mutual funds, the effect is more indirect. If interest rates rise, it may affect a company’s ability to borrow or may increase its debt repayment expenses. In turn, this may pull down the company’s stock price.

Similarly, with property investments, rising interest rates may impact a developer’s ability to complete projects with borrowed capital and a home buyer’s ability to purchase property or keep servicing property loans, thus dragging down property prices.

Credit risk

While interest rate risk impacts borrowers, credit risk impacts lenders (investors). In any debt transaction, the borrower agrees to pay the lender a certain interest over and above the principal repayment. Credit risk is the probability of the borrower defaulting on her debt obligations and failing to return the principal, interest, or both.

Borrowers in the debt market can be the government, financial institutions, public sector units (PSUs), or private companies. Credit risk is the lowest for securities like G-secs and bonds issued by the government or T-Bills issued by the RBI since the government or RBI cannot default under any circumstance barring rare economic collapse.

Credit risk is low for bonds issued by PSUs and for bank deposits. While the former is underwritten by the government, the latter is insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC) up to `5 lakh. Debentures and Commercial Papers issued by private firms carry varying degrees of risk based on their credit rating.

Liquidity risk

This is the probability that your investment cannot be converted at fair value into cash when needed. Liquidity risk is the highest for property investments since it may take months or even years to sell it at the right price. It is high also for investments like SGB, RD, SCSS, or PPF where there may be no liquidity at all for some years initially. Liquidity risk for equity investments is high in the short term but low in the long term.

Market risk

Whenever any security is traded in the open market, there is the risk of its price fluctuating. This happens due to the forces of demand and supply, and any perceived difference between the security’s market value and true value. Thus, company shares, traded bonds, mutual fund units, gold ETFs, REIT units are subject to market risk.

As an investor, it is always recommended to understand the investment risks involved before taking any decision.

The writer is founder, Hermoneytalks.com.

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