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Investing in stock market - Investment risk, an essential evil

14 Oct 2013 - {{hitsCtrl.values.hits}}

We tend to think of ‘risk’ in predominantly negative terms, as something to be avoided or a threat that we hope won’t materialize. However, in the investment world, risk is inseparable from performance and rather than being desirable or undesirable, risk is simply necessary. Understanding risk is one of the most important parts of financial education. This article will examine the ways that we measure and manage risk when making investment decisions.
What is investment risk?
Investment risk is defined as the chance that an investment’s actual return will be different than expected. This includes the possibility of losing some or all of the original investment. Those of us who work hard for every rupee we earn have a harder time parting with money. Therefore, people with less disposable income tend to be, by necessity, more risk averse. On the other end of the spectrum, day traders feel if they aren’t making dozens of trades a day, there is a problem. These people are risk lovers.
What are the types of investment risk?

Foreign-exchange risk - When investing in foreign countries you must consider the fact that currency exchange rates can change the price of the asset as well. Foreign-exchange risk applies to all financial instruments that are in a currency other than your domestic currency. As an example, if you are a resident of Sri Lanka and invest in a Canadian stock in Canadian dollars, even if the share value appreciates, you may lose money if the Canadian dollar depreciates in relation to the Sri Lankan rupee.
Credit or default risk - Credit risk is the risk that a company or individual will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors who hold bonds in their portfolios.
Systematic risk - Systematic risk influences a large number of assets. A significant political event, for example, could affect several of the assets in your portfolio.
Unsystematic risk - Unsystematic risk is sometimes referred to as ‘specific risk’. This kind of risk affects a very small number of assets. An example is news that affects a specific stock such as a sudden strike by employees.
Country risk - Country risk refers to the risk that a country won’t be able to honour its financial commitments. When a country defaults on its obligations, this can harm the performance of all other financial instruments in that country as well as other countries it has relations with.
Political risk - Political risk represents the financial risk that a country’s government will suddenly face if it changes its policies.
Interest rate risk - Interest rate risk is the risk that an investment’s value will change as a result of a change in interest rates. This risk affects the value of bonds more directly than stocks.
Market risk - This is the most familiar of all risks. Also referred to as volatility, market risk is the day-to-day fluctuation in stock prices. Market risk applies mainly to stocks. As a whole, stocks tend to perform well during a bull market and poorly during a bear market - volatility is not so much a cause but an effect of certain market forces. Volatility is a measure of risk because it refers to the behaviour or ‘temperament’, of your investment rather than the reason for this behaviour. Because market movement is the reason why people can make money from stocks, volatility is essential for returns and the more unstable the investment, the more chance there is that it will experience a dramatic change in either direction.

Assessing risk tolerance

When it comes to investing, risk and reward go hand in hand. The phrase ‘no pain, no gain’ – comes close to summing up the relationship between risk and reward. All investments involve some degree of risk.
The reward for taking on risk is the potential for a greater investment return. If you have a financial goal with a long time horizon, you may make more money by carefully investing in higher risk assets, such as stocks or bonds, than if you limit yourself to less risky assets. On the other hand, lower risk cash investments may be appropriate for short-term financial goals.
An aggressive investor or one with a high risk tolerance is willing to risk losing money to get potentially better results. A conservative investor or one with a low risk tolerance favours investments that maintain his or her original investment.
Hence, the risk-return trade-off is a vital factor to be considered prior to investing. It is the balance an investor must decide on between the desires for the lowest possible risk for the highest possible returns. Remember to keep in mind that low levels of uncertainty (low risk) are associated with low potential returns and high levels of uncertainty (high risk) are associated with high potential returns.
Determining your risk preference
Deciding what amount of risk you can take on is one of the most important investment decisions you will make. How does an investor determine how much risk he or she can handle? Every individual is different and it’s hard to create a steadfast model applicable to everyone but here are two important things you should consider when deciding how much risk to take.

Time horizon

Before you make any investment, you should always determine the amount of time you have to keep your money invested. If you have Rs20,000 to invest today but need it in one year for a down payment on a new house, investing the money in higher-risk stocks is not the best strategy. The riskier an investment is, the greater its volatility or price fluctuations are. So, if your time horizon is relatively short, you may be forced to sell your securities at a significant loss.
With a longer time horizon, investors have more time to recoup any possible losses and are therefore, theoretically be more tolerant of higher risk. For example, if that Rs.20,000 is meant for a holiday bungalow that you are planning to buy in 10 years, you can invest the money into higher risk stocks because there is be more time available to recover any losses and less likelihood of being forced to sell out of the position too early.

Bankroll

Determining the amount of money you can stand to lose is another important factor of figuring out your risk tolerance. This might not be the most optimistic method of investing. However, it is the most realistic. By investing only money that you can afford to lose or afford to have tied up for some period of time, you won’t be pressured to sell off any investments because of panic or liquidity issues.

The more money you have, the more risk you are able to take and vice versa. Compare, for instance, a person who has a net worth of Rs.500,000 to another person who has a net worth of Rs.5,000,000. If both invest Rs.25,000 of their net worth into securities, the person with the lower net worth will be more affected by a decline than the person with the higher net worth. Furthermore, if the investors face a liquidity issue and require cash immediately, the first investor will have to sell off the investment while the second investor can use his or her other funds.

(To be continued next week)
(Source: Investopedia)

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Investing in stock market - Investment risk, an essential evil

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