Risks - Understanding Risk in Investments

6 min read

RISK

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Risk is present all around us and permeates our very fabric of life. For instance, while crossing the road, there is always a risk of getting hit by a vehicle if precautionary measures are not undertaken. While studying for an exam, there is a risk that what you studied would not be tested. When you’re breathing, there is the risk that you will inhale bad air and choke. The risk is the degree of uncertainty in any stage of life

RISK & INVESTMENTS

It is important to understand that, risk is present or there is a certain degree of it in every form of investment you undertake.

Do recall that investments can be defined as the buying of assets or securities for which you EXPECT a RETURN on these securities. Risk can therefore be defined as the POSSIBILITY of an investment bringing a result OTHER THAN ANTICIPATED

When you hear risk, most people think about losing EVERYTHING, but even gaining a return less than what you were expecting can be classified also as risk. Thus, Risk basically is UNCERTAINTY

RISK - REWARD TRADE OFF

Again, you may have heard the expression “the higher the risk, the higher the return”. This statement actually omits a KEY term! The actual statement should be “the Higher the risk, the higher the EXPECTED return”. That is to say NOTHING is guaranteed! It is merely an anticipated compensation for the risk you’re undertaking! Even government securities which are used as proxies for Risk free investments can actually go bad

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MAIN TYPES OF RISKS

There are two broad types of risks and underneath them are various examples of risk that you may face as an investor. The two types of risk are systematic and unsystematic risk. Therefore your total risk when you’re investing can be mathematically shown as:

TOTAL RISK=Sytematic Risk + Unsystematic Risk

i. SYSTEMATIC/ MARKET RISK

Systematic risk refers to the risk inherent to the entire market. This means it affects everyone or all the companies in a given market segment or the total market. These risks are highly unpredictable and not easily controlled as they are usually external and not in the control of the investor. Systematic risk is also termed as “undiversifiable risk” and is impossible to completely avoid.

As an investor, below are some systematic risk that you will face:

a. Inflation Risk

This risk refers to the loss of purchasing power due to an increase in inflation such that cashflows/returns from an investment is not worth as much as in the future. For example, you bought a 4 year GHS 10,000 government bond at say 15% today and inflation was say 9%. This means your REAL return is 6%.

[Real Return=Nominal Return - Inflation Rate]

Assuming in the next two years inflation moves to say 14%, your real return drops to 1%. To further illustrate, the things you can buy with the returns/cashflows/coupons (750ghs) on the bond today would not buy the same thing 2 years from now

b. Interest Rate Risk

From finance 101, you learn “When interest rates rise, bond prices fall” . I will explain this using an example. If Kofi has a 2 year 1000ghs government bond at say 10% coupon/interest rate and general interest rates increase and a similar 2 year bond is going for 15% is purchased by Kwesi. You can deduce that at the same amount invested( face value), Kwesi is earning more (150>100) than Kofi at the same risk. Now, if Kofi would want to capitalize on the current rates and sell his bond to Kojo and buy the new one, he would have to incentivize the person buying (Kojo) by reducing the cost of the 1000 ghs bond to say 800 ghs so that the person buying would have an EFFECTIVE YEILD close to the 15% as the coupon on the bond would still be 10%. Otherwise why would he buy Kofi’s bond if he can get a similar one at an even better rate. Thus the price of his bond has fallen because interest rates have risen and there are better opportunities on the market.

c. Political Risk

Political Risks stems from political changes to public policy, tax laws, economic activities, threat of war, government styles(military rule), changes in government in a country. Instability affecting investment returns could even come from other foreign policymakers. Let me use the recent US- China trade wars as an example where the US announced some increased tariffs in for good imported from China. Now when the tensions started, investors moved to safer havens/ securities like gold, therefore affecting the financial markets. Also the individual businesses who exported goods to the US now have to deal with increasing their prices of their goods to cater for the increased taxes which may lead to reduced business activities. To further illustrate the Chinese GDP industrial output fell to its lowest levels in 17years!

d. Currency Risk

Investors or companies that have securities or business operations across national borders are exposed to currency risk that may create unpredictable profits and losses. Currency risk is also referred to as Exchange Rate risk. For example, Kwesi bought a 1 year 5% 1000$ US bond at a time where the exchange rate was 1$=5ghs. So at the time of purchase he had to exchange 5000ghs for the 1000$. Assuming at the end of the year, the cedi appreciates against the dollar to say $1=4.7ghs, on maturity kwesi will have 1050$. But if he’s to convert it to his local currency say cedis, he will have less than he initially invested. i.e GHS 4,935.00. Thus even though you may have gained in dollar terms the exchange rate has actually caused a loss on the investment.

ii. UNSYSTEMATIC/ IDIOSYNCRATIC/ COMPANY SPECIFIC RISK

As the name suggests, these risks are Company, sector or industry specific and does not necessarily affect everyone in the market. These risks can be reduced through diversification. They can stem up as a result of a new regulation, from competition, technology and others. Examples of such risks include:

e. Liquidity Risk

“Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price”- some financial securities are very difficult to buy or sell easily. Some unpopular shares on the GSE face such situations. So if you’re an investor and you hold such shares and you want to sell, it becomes a challenge and you may have to take some significant losses. Some real estate investments also have the same challenges. A $300,000 home might have no buyer when the real estate market is down, but the home might sell above its listed price when the market improves. The owner might sell the home for less and lose money in the transaction if he needs cash quickly.

f. Credit risk

It refers to the risk or potential that a lender may not receive the owed principal and interest from the borrower. In Ghana there has been cases where borrowers’ have failed to repay a loan or meet contractual obligations. Example was DKM failed to pay it’s depositors

g. Concentration Risk

Concentration risk is a term which refers to the level of risk in a investors portfolio arising from concentration to a single counterparty /investment firm, asset class, sector or country. Sometimes investors believe some sectors deliver superior returns than others and may have a huge portion of their investments in there. Thus any small issue affects the whole portfolio and the implication of concentration risk is that it generates such a significant loss that recovery is unlikely. Investments within the same industry, geographic region or security type tend to be highly correlated, meaning that what happens to one investment is likely to happen to the others. For example investing only in the financial services sector of the stock exchange and a major policy affects how they operate will likely amplify potential losses if so happens.

Other Examples of unsystematic risk include business risk, settlement risk, reinvestment risk

How to REDUCE Unsystematic risk

Unsystematic risk can be REDUCED through diversification

To achieve this, the investor can diversify his portfolio so the revenues are not solely dependent from a few products only.

Thus spread your investments among different industries (such as banking or food and beverage, telcos) and asset classes i.e equities, bonds, tbills and fixed deposits.

In conclusion: KNOW YOUR RISK APPETITE

What is your Risk Tolerance level? How much risk are you willing and able to accept? Risk tolerance is determined by your personality, age, job security, health, net worth, emergency fund, and the length of your investing horizon. There could be other factors but these are basically the most crucial.

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