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Major Types of Investment Risks for Stock Investors July 19 2017Investment Risks for Stock Investors

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What are the major types of risks in investment?

Almost all of us who invest in the stock market are looking for a risk-free investment which can generate good returns. However, it is impossible to have a risk free investment. Investing in stock market is a risky affair. Albert Einstein once said, “A ship is always safe at the shore, but that is not what it is built for.” This clearly tells us that more the risk an investor is willing to take, the more is the potential for higher returns.

There are some risks on which you can have your control while others are beyond your control. So an important aspect of investing in stock market is, understanding the types of investment risks and identifying the ways to minimize the negative effects of risks on your portfolio. In this article, we will talk about the major types of investment risks. For an understanding of how to manage risk, refer to our blog – 6 Ways to Reduce Stock Market Risks. So let us understand the different types of risks that an investor faces; but before that let us understand the meaning of risk.

What is Risk?

The risk is the possibility for an investor to experience a downside in the overall performance of the stock market or the price of his stock in particular.

Types of Investment Risks

1. Market Risk

Market risk is also called as systematic risk. Market risk is the risk in which an investor can lose due to factors or events that affect the financial market’s overall performance. These factors include natural disasters, political turmoil, changes in interest rates, terrorist attacks, inflation, recessions, etc. Market risk impacts the entire economy and share market. It affects all the stocks in the same manner and hence it is impossible to eliminate this risk by diversification of the portfolio. The main types of market risks are currency risk, equity riskinterest rate risk, etc.

2. Specific Risk

Specific risk is also called as unsystematic risk. As the name suggests, specific risk is specific to a particular industry or company. It does not affect the entire market. Here an individual company or small group of companies can have problems like product failure, incompetent management, employee strike, new government regulation affecting a particular group of companies, etc which leads to fall in the price of the stock of that company. However, one can eliminate specific risk by diversification of the portfolio.

 3. Volatility Risk

Volatility risk is the possibility of change in the price of the portfolio due to volatile factors. It can be majorly seen in derivative instruments where the price of derivative instruments changes due to volatility in it's under lying asset. In simple words, it is the amount of uncertainty or risk of changes in a security's value over a short time period in either direction. 

4. Interest Rate Risk

Interest rate risk is the risk of losing money due to change in the rate of interest. Interest rate risk majorly impacts debt investments such as bonds or NCDs. There is an inverse relationship between interest rate and the price of bond - when the interest rate goes up, the price of bond declines and vice versa.  However, one can reduce the impact of this risk by holding the bonds until maturity.

5. Default Risk

Default risk is also called as credit risk. It is the risk of non-payment of principal and interest amount by the borrower. This is one of the most infringed risks especially in the case of unsecured loans as they are not secured against any security. Hence it is advisable to look at the credit ratings of the company before you invest your hard earned money in company deposits or debentures.


6. Inflation Risk

Inflation means a general increase in prices with a fall in purchasing power. In simple words, when prices shoot up, the purchasing power of your money goes down. You will now be able to purchase fewer goods and services with the same amount of money. Inflation risk is the risk of losing the purchasing power of your investments. Inflation risk majorly impacts debt investments like bonds and hard assets like gold and commodities.


7. Reinvestment Risk

Reinvestment risk is the risk of loss arising due to reinvesting the principal or interest amount at a lower interest rate. Let us say, you bought a bond paying 5% and it is about to mature. Now the interest rates drop and if you reinvest the amount at 3%, it will amount to reinvestment risk. However, you can escape the reinvestment risk if you intend to spend the amount at maturity.


8. Liquidity Risk

Liquidity risk arises when an investor is not able to find a buyer for the asset he is holding. Generally, the equity and bonds are liquid. The buyers for them are easily available. However, assets like old stamps, coins, real estate, art work, etc. do not often have buyers for them. This makes these assets illiquid. When the owner of such assets needs money, he has no other option but to sell them at a fairly lower price after suffering substantial losses. The best way to overcome such loss is to wait for the right buyer or borrow money from banks/financial institutions if funds are needed urgently.


9. Political Risk

Political or regulatory risks are the risks associated with the economic environment and government policies related to different matters of the country. Whenever government frames a policy that is unlikely to receive a positive reaction from the respective sector of the economy, it leads to the downfall in the prices of the shares of that sector. Similarly, when the government changes, the new government comes with new economic policies and agendas leading to instability and change in economic ideology. This creates panic among the investors leading to selling of the shares and ultimately leads to the downfall in price. However, one can overcome this risk by not falling prey to the panic and holding the shares in the portfolio. Wait and watch is ideal in such scenarios.


The Bottom Line

These are some of the major types of investment risks in the stock market. Coming back to the same point, there is no such thing as a risk-free stock or investment. As an investor, the best thing you can do is analyse the risks before you buy a particular stock, review your existing investments and figure out which risks really affect you. You must also consider the amount of risk that you are comfortable to take. All said and done, even though every stock faces some or the other risks, the rewards of investing can still far outweigh them.

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