Investment: Types of Risk

After understanding what is risk associated with Investment in the previous post, now you can understand their types to have better idea - Systematic and Unsystematic Risk.

Systematic Risk (External Risk)

Market Risk, Interest Rate Risk and Purchasing Power Risk are grouped under systematic risk.

a) Market Risk

Sources of Risk: Market Risk is referred to as stock variability due to
changes in investor's attitudes and expectations.

The investor's reaction towards tangible and intangible events is the chief cause affecting 'market risk'.

The first set, that is the tangible events, has a 'real' basis but the intangible events are based on a Psychological basis or reaction to expectations or realities.

Market Risk triggers off through real events comprising political, social and economic reasons. The initial decline or 'risk' in market price will create an ecomotional instability in investors and cause fear of loss or create an undue confidence, relating to prosperity and profit. However, investors are more reactive towards decline in prices rather than towards increase in prices.

Market Risks cannot be eliminated while financial risks can be reduced. Through diversification also, market risk can be reduced but not eliminated because prices of all stocks move together and any equity stock investor will be faced by the risk of a downward market and decline in security prices. Market Risk includes such factors as business recessions, depressions and long run changes in consumption in the economy.

b) Interest Rate Risk

There are four types of movements in prices of stocks in the market. These may be termed as:

a) Long Term

b) Cyclical (bull and bear markets),

c) Intermediate or within the cycle, and

d) Short term.

The prices of all securities rise or fall depending on the change in interest rates. The longer the maturity period of a security the higher the yield on an investment and lower the fluctuations in prices.

Shorter term interest rates fluctuates at great speed and are more volatile than kinds of securities and also buying securities of different maturity date.

Interest Rate Risk can also be reduced by analyzing the different kinds of securities available for investment. A Government Bond or a Bond issued by the financial institution like IDBI is risk less bond.

Even if government bonds give a slightly lower rate of interest, in the long run they are better for a conservative investor because he is assured of his return. Moreover, government bonds are made more attractive by additional advantages to tax benefits. Therefore, one way to avert interest rate risk would be to purchase government securities.

The direct effect of increase in the level of interest rates will raise the prices of securities. High interest rates usually lead to lower stock prices because of diminished demand by speculators who purchase and sell by using borrowed funds and maintaining a margin. Investors should, during times of high rate of interest, purchase indirect securities of financial institutions and avoid purchasing securities of the corporate sector in order to reduce the rate of risk on securities.

This switching over of securities is not practical in the actual practice of making investments. The Brokers and Speculators can, however, use this as a hedge against possible occurrences of loss.

c) Purchasing Power Risk

Purchasing Power Risk is also known as Inflation Risk. This Risk arises out of change in the prices of goods and services and technically, it covers both inflation and deflation periods.

During the last two decades, it has been seen that inflationary pressures have been continuously affecting the Indian Economy. Therefore, in India, Purchasing Power Risk is Associated with Inflation and rising prices in the economy.

Inflation in India has been either 'Cost Push' or 'Demand Pull'. This type of inflation has been seen when costs of production rise or when there is a demand for products but there is no smooth supply and consequently prices rise.

All investors should have an approximate estimate in their minds before investing their funds of the expected return after making an allowance for purchasing power risk.

The allowance for rise in prices can be made through a check list of the 'Cost of Living Index'

The behavior of purchasing power risk can in some ways be compared to interest rate risk. They have a systematic influence on the prices of both stocks and bonds.

Unsystematic Risk (Internal Risk)

The Unsystematic risk which affects the internal environment of a firm or industry although peculiar industry also causes variability of returns for a company's stock.

The two kinds of unsystematic risks in a business organization are 'Business Risk and Financial Risk'.

These risks are unique inshore and arise out of the uncertainty surrounding a particular firm or industry due to factors like labor strike, consumer preferences and management policies.

These uncertainties directly affect the financing and operating environment of the form. These risks can owing to these considerations be said to complement the systematic risk forces.

As these occur due to the internal changes that take place within the industry, they are called internal risks.

Business (Operating) Risk

All the corporate organizations aim at providing a certain level of dividend income to their shareholders. They also hope ploughing back of some profits. Its operating level of earnings measures the business risk. The business risk will be low, moderate or high.

Business Risk is also classified as internal business risk and external business risk.

Internal business risk is represented by a firm's limiting environment within which it conducts the business. It differs from business to business in different degrees.

It is the frame work within which the firm conducts its business drawing its efficiency largely from the constraints within which it functions. This risk can be identified through rise and decline of total revenues as indicated in the firm’s earnings before interest and taxes (EBIT).

A firm with high fixed costs has large internal risk because the firm would find it difficult to curtail its expenses during a sluggish market.

Internal business risks can be reduces by any of the following methods:

i) Keep the fixed expenses low

ii) Diversify its business into a wide range of products

iii) Cut cost of production through other techniques and skills of management

External Business Risks are caused by factors that are beyond the control of a firm. These are responsive to specific operating environmental conditions.

These are due to the following factors:

a) Business Cycle

b) Demographic Factors (Geographical distribution of population by age, group and race)

c) Political Policies (Changes in decisions of Government)

d) Monetary Policies and Fiscal Policies of the RBI

e) Economic Environment of the Economy

This external business risks can be reduced and avoided to some extent by

a. Careful planning of the future

b. efficient implementation of the firms

c. problem solving by tactful guidance

d. study about market environment

e. concentration of population with regard to purchasing power, taste, preference etc.

f. enacting new business policies

Financial Risk

It is associated with the method through which it plans its financial structure. The capital structure should have a stable earning. As long as the earnings of the company are higher than the cost of borrowed funds, the earnings per share in ceases. The large amount of debt financing also increases their risk. It is found that variation in returns, very often causes financial risk.

Financial Risk is stated as being between EBIT and EBT (Earnings Before Interest and Taxes minus Earnings before Taxes) when the revenue. Cost and EBIT of a firm are variable, it implies business risk.

Financial Risk can be reduced and avoided to a greater extent by many measures stated as follows:

a) Excessive debt is to be avoided

b) Constantly test its debt to fixed assets, debt to net worth, debt to working capital etc.,

c) Give a coverage of interest charges and preferred dividends by net income after taxes.

Now you might have understood Risks & its types in Investment, so beware of Risks involved in investment before you begin to invest.

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