Risk is an important component in assessing the prospects of an investment. Most investors while making an investment, consider less risk as favorable. The lesser the investment risk, more lucrative is the investment. However, the thumb rule is the higher the risk, the better the return. In this article, we will talk about what investment risk is and its different types.
What is “Investment Risk”?
Investment risk can be defined as the probability or likelihood of occurrence of losses relative to the expected return on any particular investment.
Simply speaking, it is a measure of the level of doubt about achieving the returns based on the expectations of the investor. It is the extent of unexpected results to be realized.
Types of Investment Risk
In any investment you make, keep in mind that risk is an inevitable thing in the world of investment. That also means you always find yourself close to different types of risk. Here are the types of investment risk and how they affect your investment returns.
Interest Rate Risk
Interest rate risk is the possibility that a fixed-rate debt instrument will decline in value as a result of a rise in interest rates. Whenever investors buy securities that offer a fixed rate of return, they are exposing themselves to interest rate risk. This is true for bonds and also for preferred stocks.
Business risk refers to a risk associated with a particular security. It refers to the risk associated with a specific issuer of a security. Generally, all businesses in the same industry have similar types of business risk but used more specifically, business risk refers to the possibility that the issuer of a stock or a bond may go bankrupt or be unable to pay the interest or principal in the case of bonds.
This refers to the possibility that a particular bond issuer will not be able to make expected interest rate payments and/or principal repayment. Typically, the higher the credit risk, the higher the interest rate on the bond.
This applies to municipal bond offerings and refers to the risk that a security issued with tax-exempt status could potentially lose that status prior to maturity.
Call risk refers to the possibility that a debt security will summon prior to maturity. It is most prevalent when interest rates are falling, as companies trying to save money will usually redeem bond issues with higher coupons and replace them on the bond market with issues with lower interest rates.
Also known as purchasing power risk, the inflationary risk is the chance that the value of an asset or income will be worn down as inflation shrinks the value of a country’s currency. Put another way, it is the risk that future inflation will cause the purchasing power of cash flow from an investment to decline.
Liquidity risk refers to the possibility that an investor may not be able to buy or sell an investment as and when desired or in sufficient quantities because opportunities are limited. A good example of liquidity risk is selling real estate.
Market risk, also called systematic risk, is a risk that will affect all securities in the same manner. In other words, some factor that cannot be controlled by diversification causes it. This is an important point to consider when you are recommending mutual funds, which are appealing to investors in large part because they are a quick way to diversify.
A social or political risk refers to the possibility of nationalization, unfavorable government action or social changes resulting in a loss of value. Since some congress of certain countries has the power to change laws affecting securities, legislative risk refers to any ruling that results in adverse consequences.
Currency or exchange rate risk is a form of risk that arises from the change in the price of one currency against another. Understandably, currency risk is greater for shorter-term investments, which do not have time to level off like longer-term foreign investments.
Knowing the types of risks associated with investments is essential. If you understand the fundamental concepts behind each type of risk, you will be able to make investment recommendations to your clients with great confidence.
See Also: Warning Signs of a Risky Investment
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