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Identifying Investment Risk

INVESTMENT RISK & 10 RISK SOURCES

Two major categories and ten sources of investment risk are identified and presented in this article. High portfolio risk may adversely affect future cash-flows of an investment and even lead to a total loss of the initial investment. Capital investment risk is divided in two major categories: systematic risk and non-systematic risk as described in (I) section.

Identifying Investment Risk -TradingCenter.org

 

(I) General Categories of Risk Separated by their Fundamental Nature


In order to deal with the investment risk first we must identify its origin. In that way, we distinguish risk into two general categories: systematic and non-systematic risk. Systematic risk is unpredictable, and therefore, it can not be identified and managed. This category includes risk deriving from events of the overall macroeconomic environment. The worst case scenarios include war and nationalization of local companies by the force of state law.

In contrast, non-systematic risk can be anticipated through the implementation of a series of risk diversification techniques. The non-systematic risk can be mainly managed through a process called diversification of risk. The concept of that technique can be captured in the phrase "Do not put all your eggs in one basket". Risk diversification procedures are extremely important in every investment portfolio -especially to those investment portfolios heavily exposed in financial securities like corporate-bonds and stock-equities.

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(II)10 Special Categories of Risk and how they can be managed


Here are the 10 major categories of investment risk and techniques to deal with them.

 
1. Business Risk


Business risk in incorporated to all forms of business transaction and investment. Business risk is including both internal and external environment changes. For example the business risk may refer to a significant change in the level of competition in a particular industry (external). Even managerial changes may include forms of business risk, like the departure of a company’s CEO (internal).

How to manage Business Risk:

Portfolio diversification into many different companies and many different industries is the perfect antidote for managing business risk.
 

2. Market Risk

 

Market risk is the type of risk associated with the volatility of the financial markets. For example, market risk may arise from significant changes in the prices of raw materials in the local or international markets. Many factors may be the source of market risk like a sudden shift in the demand / supply of a commodity. For example, a natural disaster or an accident in a major oil platform in the North Sea may cause a significant increase in the price of oil on NYMEX.

How to manage market risk:

Commonly market risk is managed by the use of derivatives contracts like options, futures and swaps. In the example given before, you may buy stocks of an oil company (i.e. BP) and at the same time “bet” the price of oil downwards (i.e. short oil futures).

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3. Credit Risk or Default Risk


Credit risk is included in all forms of transactions that involving future payments. Credit risk is referring to the possibility that a future payment will not be made according to the prearranged agreement. The risk of default (non payment) in a transaction occurs widely around the world. For example the US banking industry in 2008 faced phenomenal deletion of “bad” loans as the real-estate market collapsed. Refusing of payment affects the cash-flows of an investment and therefore it is reducing investor’s value.

How to manage Credit Risk or Default Risk: Diversificate between different companies, industries and countries by focusing on Credit Ratings.

 

4. Liquidity Risk


In economic terms, liquidity may be defined as the instant available funds of an economic entity at any given time. Liquidity risk describes the inability of an entity to liquidate an investment and thus the inability to concentrate liquidity. The lack of liquidity of an economic entity may cause failure of payment agreements or may even lead to financial collapse. In other words, an investment shouldn’t be just safe but it must be also highly liquidable. Liquidity risk is usually incorporated in forms of investment that can be found in the real economy. For example an investment in the real estate market can not be liquidated instantly. Liquidity risk is also incorporated in financial markets. For example penny stocks with low volume activity can not be liquidated without price discounts.

How to manage liquidity risk:

Research on detailed forecasted cash-flows analysis, when investing in stocks. Also  you may focus your portfolio on investments that are highly liquid (government bonds, blue chips, currencies, precious metals etc.)

 

5. Interest Rate Risk

 

Interest rate risk is the risk of future diminishing investment value due to the rise of the level of interest rates. Interest rate risk incorporates risk deriving from the volatility of the basic interest rate of an economy. The basic interest rate is defined and controlled by the Central Bank of a country (i.e. FED for US and ECB for euro zone) and it affects hugely the investment activity. When the interest rate moves up, investments become less attractive and if they obtain high levels of debt their cash-flows are disturbed.

How to manage liquidity risk:

Concentrate into companies that are not highly exposed into debt (especially short-term debt). In addition, the use of derivatives contracts like options, futures and swaps offer hedging against interest rate volatility.

6. Financial Risk


Financial risk is incorporated in investments that are using external funding (i.e. bank lending). This type of risk by nature is associated with the interest-rate risk mentioned before (5). The more a company increases its debt exposure the more possible it is that this company will be unable to pay its future financial obligations.

How to manage financial risk

For companies, the key to manage financial risk is to transform short-term debt to long-term debt and use also balloon-type lending methods. For investors of the stock-market, the only antidote is diversification among different companies, industries and countries and focusing also on Credit Ratings.


7. Inflation Risk


When inflation of an economy increases that means that prices soar and thereby the purchasing power of all economic entities is weakening. Inflation is seen by many economists as the “hidden tax”. Ironically, the perceived as "safe" investments -such as bank deposits and government bonds are more vulnerable to inflation risk. In contrast, investments perceived as “risky" -such as stocks and equity mutual funds- are less exposed to inflation risk.

How to manage inflation risk:

Portfolio diversification among different countries and different economic zones may prove an effective tool to deal with inflation risk.

  

8. Currency or Foreign Exchange Risk

 

Currency risk is found on investments that include future payments in foreign currencies. Currency risk is the risk of losing part of your investment value due to the fluctuations of the foreign exchange market (FOREX). For example, a European investor that buys a US bond is exposed to the falling exchange rate of US dollar against Euro. Currency risk is very intense in import / export companies and their stocks.

How to manage currency risk

Portfolio diversification among different currencies and hedging risk through the use of derivatives (currency options, futures and swaps) may reduce the currency risk of an investment portfolio.

 

9. Political Risk or Country Risk


Political or country risk involves sudden changes in the legislation content of a country which may unfavorable affect (directly or indirectly) the value of an investment. For example, the introduction of a new tariff in certain imported goods or even the complete prohibition of certain imported goods / services. Other forms of political risk may include the creation of entry / exit barriers to an industry. Usually, high level of political risk is identified in investments located in countries of the 3rd World.

How to manage political or country risk 

Political risk can be managed by the overall diversification of an investment portfolio in different industries and different countries.

 

10. Systemic Risk


Systemic risk is referring to the possibility that the whole financial system will collapse. Systemic Risk is included separately to each economy but as now markets are globalized -collapse of a country may spread rapidly around the world and causing many other economies to collapse. A systemic collapse is a very rare event –but when it occurs it may lead to the total loss of the initial investment.

How to manage systemic risk:

Purchase gold and portfolio diversification in different countries and different economic zones.

 

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-In Conclusion 


Depending on the specific nature of each investment portfolio –it is possible to detect additional types of risk. Many investment tools are used to measure these 'special' hazards such as the Beta ratio used in the risk-assessment of stocks and hedge funds. Investment decisions should be made only after the overall analysis of the risk incorporated within them what is called risk-management.

 

George Protonotarios, George at Linkedin

 

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