Risks in Investing / Trading

Risk is any uncertainty that has the potential to negatively affect your financial welfare.

Money lies in managing risk, not by avoiding risk.

Taking Risk / Need for Risk depends on Risk required, Risk capacity, Risk tolerance. 

Information Risk

Financial decisions are made based on information available, this information is provided either by the manufacturer of financial products or agents/distributors/advisors or media. What will happen if this critical information is wrong or not complete? This can happen in any financial product including mutual fund (you see advertisement of 100% return in a year – these are point to point returns & completely misguiding), taking a loan (interest rate shown 9% but actually it is 16% – it is a game of Flat rate & Reducing rate) or even simple products like tax-free..

Investor-Level Risks

This is the biggest risk of all risks known are non-planning, selecting non suitable instruments / assets / sub assets, human biases, personal exigencies, income losses, non-commitment of funds, un lucky or un timing the volatile instruments, excess leverage, not diversifying across assets, time horizon, timing the markets, etc.,
The way to reduce this risk is planning your finances, cash flows, assets and liabilities, financial goals, liquidity needs, taxation of personal finance, taxation of instruments, taxation of cash flows from instruments.

Horizon risk

The risk that your investment horizon may be shortened because of an unforeseen event, for example, the loss of your job. This may force you to sell investments that you were expecting to hold for the long term. If you must sell at a time when the markets are down, you may lose money.
The way to reduce this risk is planning your finances, cash flows, assets and liabilities, financial goals, liquidity needs, taxation of personal finance, taxation of instruments, taxation of cash flows from instruments.
Another way to reduce this risk is having emergency fund, contingency fund, happiness fund, job change fund, and health fund.

Loss of Money

If you buy any asset / instruments / investment, be it a fund, or equity or bond or real estate or gold or any other asset class, there is no guarantee that you will get all of your money back when you decide to sell. Generally, the lower the risk, the lower the potential return that may come. If your objective is to grow your money or wealth, then you will have no choice but to accept a certain degree of risk.
The way to reduce this risk is risking small amounts of money, which you can afford to loss completely, ideally it can be around 0.5% to 2.00% of your net worth per investment / trade.

Leverage Risk

Appropriate level of leverage accelerates wealth creation, while over leverage kills and destroys wealth. Borrowing huge amounts of money, Intraday trading, Excessive Margin Funding, multiple times of limits, Not assessing the worst-case scenarios, are the causes of losing money. Responsible leverage creates wealth. Even SEBI has suggested maximum leverage of 2X, while with professional / practitioners / experts’ guidance, you may leverage up to 5X.

Volatility or Timing Risk

This is not a risk in itself, but a measure of how much the value of an investment goes up or down over a certain period of time. The more volatile an asset is, the more the price will change. The obvious risk is that you buy an investment while the price is high and sell it when the price is lower.
The way to reduce this risk is by having a basket of investments into multiple assets which are uncorrelated or low correlated.

Country risk

It is also called sovereign risk. Credit risk is close to zero in Government Bonds but close to zero doesn’t mean zero. What about the present condition of PIGS – Portugal, Ireland, Greece & Spain. Countries like Russia, Sri Lanka, Pakistan and many more have deferred maturity payments by issuing additional bonds.

Systematic Risk / Broad-Level Risk

This is a macro level broad-based risk, which may not be in the purview of your control. The COVID-19 pandemic and resultant economic uncertainty, the global recession, financial crisis of 2008, changes in laws and policies, market crashes, inflation / deflation, removal of stimulus, interest rate that have larger ramifications on the society, etc. are some examples of systematic risk.
The way to reduce this risk is staying invested for the long term.

Social / Political Risk

The political scenario, policy decisions of the government, the administration/governance, how the dispensation handles multi-lateral ties with other nations and taxation policies/laws are some of the factors that constitute a political risk and weighs on the investments you make.
The way to reduce this risk is investing across the geographical boundaries of your country / world. 

Currency Risk

This risk arises due to changes in the foreign exchange rate and when you have investments in any other currency apart from your home currency. If the value of the foreign currency falls, it weighs on your return on investments as well. Currency risk is the possibility of losing money due to unfavourable moves in exchange rates.
The way to reduce this risk is investing across the geographical boundaries of your country / world or hedging with the cross currencies.

Non-systematic Risk / Segment-Level Risk

This risk is at the micro-level and unique to a particular industry and/or company within the industry. So, it is specific and, in a sense controllable, by the investment decision you take. Some examples are, downgrades, strong competition, bad leadership, legal tussles, patent issues faced by a pharmaceutical company; the food and drug administrator banning a particular drug; slump in the housing sector, etc.
The way to reduce this risk is investing across diverse companies.

Industry-Level Risk

Industry-level risks are things that can impact entire industries (or even sectors). While they may affect stocks outside the industry, their primary impact is on stocks within the industry. Few examples are Restrictive Legislations, currency changes, commodity costs, technological changes, interest rates hikes, etc
The way to reduce this risk is investing across diverse sectors.

Business / Company Level Risk

This risk is specifically associated with the business of the company you may have invested in. For instance, the company may lose market share to the competition, suffer losses, run out of capital, face problems on account of poor management or even face bankruptcy. These have a bearing on your investments.
The way to reduce this risk is diversifying across businesses and industries and pay attention to the management quality and fundamental analysis.

Liquidity risk

This occurs due to the inability to convert a security or asset to cash easily without a loss of capital/ income. Real Estate and Other Alternative Investments have highest liquidity risk, while cash or bank account has least liquidity risk.
The way to reduce this risk is having emergency fund, contingency fund, happiness fund, job change fund, and finally investing across liquidity categories of multiple assets. For listed space securities, track the average monthly volumes, value traded, free float of the issue, etc… 

Concentration Risk

When your investment portfolio is skewed to one particular asset class, one or two sectors, a particular theme or one or two issuers of securities, then it is a concentration risk. You may not earn a worthy return if the asset class or sector underperforms.
The way to reduce this risk is to follow asset allocation and diversification.

Credit Risk

Credit risk arises from the failure of one party to fulfil its financial obligations to another party. Some examples of credit risk include failing to pay interest or principal on a loan, payment capacity is downgraded. In times of economic uncertainty, the credit risk usually intensifies. High Credit ratings are low yielding, while low credit ratings are high yielding.
The way to reduce this risk is investing across the credit ratings and maturities.

Inflation risk

Inflation is an overall increase in the price of commodities and products in an economy. When the inflation rate rises, companies have to spend more to procure the same amount of raw material.

Interest rate risk

When interest rates move up, the value of debt and fixed income securities goes down and vice versa. Over a long period, interest rates could see several cycles of ups and downs. So, a debt portfolio could see fluctuation in its value.

The way to reduce this risk is to invest in a shorter duration portfolio in a rising interest rate scenario and increasing the duration of portfolio in a declining interest rate scenario.

Re-investment risk

This is when you are unable to reinvest the proceeds received from an earlier investment, at a rate comparable to the current interest rate. You may have typically experienced this while renewing your bank fixed deposit, where you discover that interest rates have moved down compared to earlier. Usually, bonds that are long term in nature and offer high coupon pay-outs, are exposed to high re-investment risk.
The way to reduce this risk is holding a portfolio of fixed-income instruments and debt securities with diverse maturities.

Commodity price risk

Commodity price risk is the possibility that commodity price changes will cause financial losses for either commodity buyers or producers. Buyers face the risk that commodity prices will be higher than expected.

Operational Risk

Operational risk can be defined as the “risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events.” It includes legal risk but excludes business, strategic, and reputational risk.

Taxability risk

Just like regulations surrounding companies, there are taxability rules as well that govern the company whose stock you have purchased. And given that the government tends to keep changing tax rules based on the needs of the economy, the stock price of the company whose sector’s tax laws get tweaked can get affected.

Technological Risk

This risk arises due to rapid changes in the technology of the department or company or industry or technological failures of a system.

Valuation downgrade Risk

Select companies / industries trade a high valuation and when valuation is too high you will not make money even in the long run. When valuation multiples are downgraded significantly, despite the growth of business valuation, you may not make money for a longer period of time.

Fund Management Risk

This risk kicks in when strategy / fund / portfolio manager deviates from the stated investment / trading strategy.
If the strategy / fund / portfolio manager fails to generate alpha or underperforms vis-à-vis the respective benchmark index, it is a risk.
The way to reduce this risk is putting money into strategy / schemes / fund that follows robust investment / trading processes to achieve the stated objectives.

Rebalancing Risk

In strategic / tactical allocation, instruments are regularly and frequently rebalanced and closely monitored. However, this exercise may result in losing a growth opportunity.
The way to reduce this risk is following your strategic and tactical asset allocations religiously, following the process and ignoring the outcomes in short run, and achieve the objectives in the long run.