Demystifying Investment Risk: How to Manage Investment Risk?

Friday, February 7 2025
Source/Contribution by : NJ Publications

Investing is an essential way to grow wealth, build financial security, and achieve long-term needs such as retirement, education, or buying a home. However, every investment comes with some level of risk. We all have heard the phrase "Investments are subject to market risk".

Understanding and managing investment risk is a crucial part of the investment process that can help you make more informed decisions and ultimately enhance your financial well-being. In this article, we will be decoding this phrase by understanding the different types of risk in investment that you might incur while investing.

What is Investment Risk?

Simply put, investment risk refers to the potential for loss of your principal investment. It's the uncertainty associated with the expected return on investment. Risk exists in all types of investments, whether in stocks, bonds, real estate, or commodities but the type and extent of risk are different. Thus it is important to understand the different types of risk and evaluate its impact to find the right solution to deal with it.

1. Systematic Risk (Market Risk):

   It is the primary risk factor that affects your investments. This risk refers to the fluctuations in the overall market due to factors such as economic conditions, political events, and investor sentiment. Systematic risk cannot be mitigated through portfolio diversification. Some of the examples of Systematic Risk are:

   Price Risk: Refers to the potential for an asset's market price to fluctuate, leading to a loss or reduced value of your investment.

   Inflation Risk: The risk that inflation will erode the purchasing power of your investment returns. For example, if inflation outpaces your investment’s return, your real return (the return after adjusting for inflation) could be negative, even if you earn a nominal profit.

   Interest Rate Risk: Changes in interest rates can affect the value of bonds and other fixed-income investments. As interest rates rise, the value of existing bonds typically falls, as investors demand higher yields from new bonds.

2. Unsystematic Risk (Company/Industry Specific Risk):

   This is the risk associated with a particular company or industry. For example, a company's stock might fall due to poor management decisions, product recalls, or regulatory fines. Unlike market risk, unsystematic risk can be mitigated by diversification.

3. Credit Risk:

   It is a type of investment risk associated with fixed-income securities like bonds and debentures. The risk that a borrower (e.g., a company or government) will fail to meet its financial obligations, leading to a loss for the investor. Borrowers with lower credit ratings are more likely to default, which can lead to loss of principal and interest payments.

4. Liquidity Risk:

   This risk arises when you cannot easily buy or sell an investment due to a lack of buyers and sellers in the market. This often occurs with investments in less-liquid markets or with assets that are not traded frequently, such as real estate or private equity.

5. Reinvestment Risk:

   The risk is that you won't be able to reinvest the proceeds from an investment (like a bond maturing) at a comparable or higher rate of return.

Managing Investment Risk

1. Diversification: Diversifying your investments across different asset classes, industries, and geographic regions is one of the most effective ways to reduce risk. By spreading your investments, you lower the likelihood that a downturn in one area will drastically impact your overall portfolio.
2. SIP in Mutual Funds: It is a strategy where you invest a fixed amount of money into an asset at regular intervals, regardless of market conditions. This approach helps smooth out the effects of market volatility and reduces the risk of investing a large lump sum during an unfavorable market condition.
3. Rebalancing: Over time, the performance of your investments will cause your asset allocation to shift. Rebalancing involves periodically adjusting your portfolio to maintain your desired allocation.
4. Long-term Perspective: Maintain a long-term investment horizon and avoid making impulsive decisions based on short-term market fluctuations. The longer your money remains invested, the greater the impact of compounding.
5. Seek Professional Advice: Consult with a qualified financial advisor for personalized guidance.

Conclusion:

Investing always involves some level of risk. However, by understanding and managing these risks effectively, you can increase your chances of achieving your financial needs. With the right knowledge, planning, and strategy, you can navigate investment risks and build a portfolio that works for you - now and in the future.