INVESTMENT RISK

According to investopedia, risk involves exposure to some type of danger and the possibility of loss or injury. In general, risks can apply to your physical health or job security. In finance and investing, risk often refers to the chance an outcome or investment’s actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment.

The greatest risk of all comes about because investors do not understand what they are buying. Frequently, they don’t have a clue as to what makes the business tick. The great investors tell us that the best way to reduce risk is to investigate what you are buying into. Don’t flail around buying this, that or the other on a whim, a tip or even broker advice. Find out about the people you are handing your money over to (the directors of the company), about the state of the industry, whether the company has any extraordinary resources and the financial standing of the firm

Different types of risk

types of risk

Systematic Risk

Systematic risk is due to the influence of external factors on an organization. Such factors are normally uncontrollable from an organization’s point of view. include recession political turmoil, changes in interest rates, natural disasters and terrorist attacks.

Unsystematic Risk

Unsystematic risk is due to the influence of internal factors prevailing within an organization. Such factors are normally controllable from an organization’s point of view.

Liquidity risk. Liquidity is the degree to which an asset can be sold quickly and easily without loss in value. Property investment assets are relatively illiquid investments because they may take weeks to sell. If a quick sale is needed, a reduction in price is usually required. Shares are generally more liquid than property, but it can still be hard to sell quickly and without moving the price against you Smaller company shares tend to be most illiquid. Many stock markets listed companies see only one trade per month.

Event risk. Event risk is the risk of suffering a loss due to unforeseen events. It could be less dramatic than war, e.g. a merger, a loss of a major contract.

 Political risk. Changes in government or government policies may affect investors. This is more usually the case in developing countries where confiscation or forced nationalization could take away all value from an overseas shareholding. Even limits on dividends can have an impact.

 Exchange rate risk. It is possible to lose money on investments abroad simply because the foreign exchange rate moves against you even if the value of the shares (when valued in the overseas currency) remains constant. However, if you are diversified internationally you may be able to take a swings-and-roundabout attitude to this risk.

Market risk. Your investment could be affected by a general slide in the whole stock market.

This can be as a result of general economic performance.

Management risk. Most fund managers (unit trusts, OEICs, investment trusts, pensions, etc.) do not consistently beat the market index average. Given this fact, you might like to save on the high fees of ‘active’ fund managers and either manage your own investments or go for low-fee ‘tracker’ funds or exchange traded funds.

Inflation risk. If you select ‘safe’ investments such as government bonds you may suffer from inflation risk. That is, what seems like a reasonable return when inflation is 2 per cent loses purchasing power if inflation rises in the future to, say, 10 per cent.

Measuring risk

Volatility

One way of measuring risk is to observe the way in which the investment swings around over a period of time. If it is highly volatile then there is a greater chance of you losing your money. If its value has been fairly constant or rising in a steady fashion, then you may feel more reassured that there won’t be a sudden plunge.

Strategies for minimizing risk

Diversification

We have all heard the adage ‘don’t put all your eggs in one basket’. Well, this applies to your investment as much as to other aspects of life. If you place all your money in one company you are vulnerable to adverse news (e.g. a product failure, chief executive’s resignation, government rule change) causing a plummet in price. So, holding one company’s shares in your portfolio will typically result in a high standard deviation(risk). However, if you split your fund between two companies, at any one time there is a fair chance that bad news affecting one is offset by good news affecting the other, so that overall portfolio returns do not oscillate as much.

Hedging

Normally, a hedge consists of taking an offsetting position in a related security. Hedging is analogous to taking out an insurance policy. Investors and money managers use hedging practices to reduce and control their exposure to risks. In order to appropriately hedge in the investment world, one must use various instruments in a strategic fashion to offset the risk of adverse price movements in the market. The best way to do this is to make another investment in a targeted and controlled way.

The lesson content has been compiled from various sources in public domain including but not limited to the internet for the convenience of the users.

By Kenneth Adu

kennethadu550@gmail.com

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