Investing in different asset classes is known to offer returns to an investor, but there are risks associated as well. Investors need to understand what is investment risk and what are the different types of risk that affect the value of their investments.
This article will provide insights on the topic. So what are the different types of risk?
- Systematic risk refers to a risk that cannot be diversified. It is the overall risk that affects the entire economy and not one specific company or a sector. Systematic risk can arise out of rising inflation, a decreasing current account deficit, rising interest rates, currency depreciation or natural disasters like flood, earthquake and pandemics like the Covid-19 pandemic we are witnessing right now.
- Unsystematic risk: This risk, on the other hand, can be diversified by the investor as it impacts a specific sector or company in a country. Unsystematic risk can be reduced by diversifying one’s portfolio across companies and industries. This risk could arise for a number of reasons affecting a company or industry. For example: trade tariffs being imposed on steel could impact all the steel companies.
- Liquidity risk: A key lesson in the basics of investing says that you must invest in such a way that you do not need to sell an asset at a lower price due to lack of demand. This can happen when you invest in assets that are not actively traded in the market. Ensure that you make enough liquid investments that you can exit whenever you wish to and at a fair price.
- Credit risk: This is one of the important types of financial risk that involves a borrower defaulting on their repayment obligation due to one or more reasons. For example, this happened in India in 2018 when IL&FS defaulted on coupon payments to bondholders. As a best practice, you must always consider buying securities that are considered and rated as safe investments.
- Inflation risk: Inflation has the power of eroding the value of your investments. It decreases the purchasing power of money over time when returns are lower than the inflation rate. For example, if you have money in a savings bank account which offers a 4% interest rate and the inflation rate in the economy is 6%, then you are actually losing the value of your money.
Hope this was a good, succinct introduction to concepts that are extremely important for an investor.
You can further learn investing with MProfit to familiarize yourself with the basics, as you embark upon your investing journey.