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Yogi Zone

Useful articles for your finance management by our team of experts

different sources of risk

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sources of riskHow can you lower risks when it comes to investing

? How to reduce investment risk?

These are common questions which arise in every investor’s mind. While transacting in various financial and physical assets, investors are exposed to different kinds of risks. Risk and Returns are two basic parameters which outline the portfolio performance; hence, it’s advisable to understand various sources of risk so as to lower them and optimise returns. A clear understanding of risk sources would also help you in asset allocation process, based on your investment personality. Risk in investments comes in the form of inflation, fluctuation in interest rate, exchange rate, political scenario etc. We will try to understand these sources of risk through this article.

Inflation Risk

Almost everyone, be it investor or saver, is exposed to risk of rising inflation. Inflation is one of the toughest enemies of portfolio returns. Rising inflation basically weakens your purchasing power. Let’s say you invested in an asset class which generates a return of 8% over a year and inflation figures are around 9% for that period. So, what did you gain at the end of one year? If you do your maths correctly, you will be surprised to know that you have basically lost 1% of your principal amount. It’s recommended to take inflation risk into consideration while deciding asset allocation and choose such asset classes which provide hedge against inflation.

 

Interest Rate Risk

Interest rate risk arises because of changing interest rate scenario in investment horizon. If your portfolio comprises of interest rate sensitive assets like bonds, interest rate risk is higher. Interest rate risk is also proportional to the time horizon of investment as it’s higher for longer maturity assets. If you are a conservative investor and your portfolio is tilted towards fixed income securities, interest rate risk should be evaluated properly and monitored at regular intervals.

 

Exchange Rate Risk

Exchange rate risk

arises due to fluctuation in value of domestic currency as compared to foreign currency. Investors are exposed to this risk, when they invest in assets of different countries or investment is done in companies whose core revenue comes from imports/exports. If foreign currency depreciates against domestic currency, the value of foreign asset also depreciates in terms of domestic currency. Similarly, if there is appreciation in foreign currency against domestic currency, the value of foreign asset appreciates in terms of domestic currency. This correlation adds to the volatility of portfolio returns and hence increases the risk.

 

Default Risk

Investments are two party transactions. There is a borrower who borrows money from a lender with a promise that he will pay back the borrowed money as per guidelines mutually agreed. But there is no guarantee that borrower will pay back the lender as per schedule. There is always an element of risk related to default of one party in two party transactions. Hence, it’s advisable to check the credit history of borrower before investing in their investment offering.

 

Reinvestment Risk

When we invest in a

financial asset

, there are some intermediate cash flows attached to it, like interest and dividend payment. Re-investment risk is the risk that the intermediate cash flows received from investments in financial securities may or may not be able to earn the same return as the original interest rate promised by the financial security. Usually, if interest rate rises, reinvestment risk reduces and if interest rate falls, reinvestment risk increases.

 

Conclusion

As we can see, risk may arise from different sources, one need to pay careful attention while planning for investments. The above list is not complete and there are other sources also. But, one thing is sure, sources of risk are basically related to the asset class you are choosing to invest into, hence they play an important role in asset allocation decision process.

Calculators:

 

Expense Based Insurance Calculator

 

Income Based Insurance Calculator


 

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