The first fortnight of this month was an interesting period. Key events such as the referendum in Italy, RBI monetary policy review, meetings of the Bank of England and the Federal Reserve gave some direction to interest rate movements.
So, how were investors, traders and speculators affected because of the interest rate movement and how did they manage the risk? Risk management is one of the key frameworks in the investing process. However, most of the time investors do not look into risk management and do not accord any importance to it in their investing journey.
Risk and investment
Risk in simple terms means possibility of danger, threat or fear. If looked from an investment point, it could mean uncertainty. It could also mean the possibility of actual return being lower than anticipated return.
Risk management in investing means having a process in place to identify, analyse and have mitigants in place to manage the risk. Nowadays, latest news, events, Whatsapp notes drive investment decisions. The quick return gets bragging rights and the adrenaline for the next investment.
Credit and interest risks
Let us bring a method to this madness and know more about investment risk. In this framework, one of the legs is market risk—the risk of investments going down in value on account of events, as noted earlier. Then there is credit risk and interest rate risk. The risk that the entity issuing the financial instruments, basically bonds, is not able to repay the principal amount is the credit risk, inherent at the time of issuance.
When the interest rate goes down, the market value of the existing bonds goes up. But then, the issuance of fresh bonds will be at lower rates. The volatility in the bond markets when RBI did not reduce the interest rates this month is the risk which investors did not factor in, especially those who had invested in the bonds in the days leading up to the RBI announcement.
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You cannot assume and control what is ‘uncontrollable’ and ‘unpredictable’. The interest rate risk also brings forth ‘re-investment risk’. This is when the bond in which you have invested has matured and a lower interest rate is prevalent. Well, being passive or active in the investment journey is not an option but a reality, and needs to be considered based on each investor’s needs.
Liquidity risks
This brings ‘liquidity’ risk into picture. We have encountered enough such situations and anecdotes, which does not enable you to sell or get out of the investment when you want to. And if you want to sell or redeem, then you need to take a cut in the price. With better healthcare, the possibility of you outliving your investment and savings is a reality, which brings into account the ‘longevity’ risk.
Knowing the risk and having mitigants in place is the approach. Do not invest based on events. Events can provide opportunities to re-visit investment strategies. Opportunity and risk come in pairs, and having a risk management framework is the key to ensure a more predictable investment journey.
The writer is founder and managing partner of BellWether Advisors LLP