Nearly every investment instrument in the world has some level of risk associated with it – some are less risky than others like mutual funds, while some instruments like derivatives carry very high-risk elements – which make them only suitable for experienced investors or speculators.
One cannot simply make an investment without considering the risk factors involved in it. The level of risk can be different for each financial market or instruments and can be mitigated by taking appropriate steps.
New as well as some of the experienced investors in Nigeria often make the mistake of ignoring the risk factors associated with the concerned financial instrument.
It is essential to identify each risk element and make a sound financial plan before you start investing to achieve the financial objective efficiently. Potential investors should also acknowledge the asset allocation, risk tolerance, time horizon before making a financial plan and making any investment decision.
Following are the common types of risks that can drastically affect your investments.
- Market Risk
An Investor can make a profit from the financial markets if he/she is able to properly judge the future market patterns & the resulting market movements are in favour of the investor.
The markets can also react in the opposite direction which may provide losses to the investor. Market risk is the most common risk that exists in most of the financial markets.
The severity or magnitude of the market risk depends upon the volatility and the nature of the financial market or instrument.
Volatility Risk arising from market movements, Equity Risk of drop in share value, Currency Risk arising from currency fluctuations in overseas investments and Interest Rate Risk involving rise of interest rates causing fall in bond prices are the common risks that affect capital market investments like bonds and stocks.
While forex trading is affected by risks arising from forex market volatility and underlying central bank interest rates, leverage, transaction, counterparty and country. And then there are specific Instrument related risks where the investors use highly leveraged complex derivatives or instruments like CFDs.
Complex financial instruments like forex & CFDs carry a higher market risk than other instruments. And bonds and fixed income securities carry lower risk.
Most market risks can be mitigated through diversification, calculating risk to reward before making an investment and by using other instrument specific risk management strategies like stop loss, safe leverage etc.
- Liquidity Risk
In financial markets, liquidity depicts the ease at which the owned asset or security can be converted into cash.
Not every financial market allows the investor to buy or sell the instruments at any moment. This inability to buy or sell the financial instruments at a fair price at the desired time is referred to as liquidity risk.
The seller might have to agree to sell at lower prices while the buyer has to pay higher prices due to liquidity risk in the market.
The liquidity risk exists due to a lack of buyers or sellers in any of the markets or inefficiency of the market or liquidity provider or broker. If the buying and selling cannot be done at the desired time, then orders cannot be executed at the desired price.
The investors must check the associated liquidity risk before making investments in any of the financial markets.
- Concentration Risk
If the whole investment amount is focused on one element of a single instrument then there is a higher probability of facing severe losses. However, if there is a large variety of financial instruments in the portfolio then the correlation of the returns is reduced.
In other words, the losses of some of the instruments will be cancelled out by the profits in other tools and there is a less probability of facing unwanted outcomes.
Investors need to ensure that their investment portfolio is well-diversified and involves different types of financial instruments from various sectors, industries, counterparties, and countries.
But. it must be noted that over-diversification of the portfolio might suppress the potential gains from a portfolio.
- Inflation Risk
Inflation is the rise in the price or reduction in the buying power of money over a prolonged time period. Most of the investments are done to counter growing inflation and maintain the buying power of the money owned by individuals.
However, the consistent rise in the price or inflationary environment might overlap the returns provided by the chosen financial instrument. This might lead to a reduction of buying power of the investment amount or lesser gains than anticipation.
Bonds and fixed income securities are the most prone to inflation risk due to low returns. Investors must ensure and monitor that their existing or chosen financial instrument are offering higher return rate than the potential future inflation rate.
- Business Risks linked to particular entity or investment
Every investment done in any of the financial markets are received or involved with an entity that can either be a business, person, government, or institution. However, these entities can sometimes fail to deliver the expected outputs due to multiple reasons related to the business, financial, credit or default.
Like some businesses may have an uncertainty of income due to their business nature like some business faced uncertainty during the Covid-19 crisis or financial structure, while some bonds or borrowers have higher chances of default or failing on their commitments resulting in poor credit ratings.
The inability of the entities to perform can result in fatal outcomes for the investors which are regarded as a business risk in finance.
This type of risk exists in almost every financial market but can be mitigated by choosing a trustworthy entity for investment and properly analysing all factors that may affect their performance.
- Political Risk
The government and its policies can greatly affect the price movements of financial markets.
International relations, trade barriers, taxation policies, legislation, and administrative restrictions play an important role in guiding the price movements of financial markets.
If any of the policies or decisions made by the government goes against the concerned financial market then it will negatively affect the price movements of the financial instruments across multiple sectors in that market.
Investors should watch out for the impact of government policies on the chosen instrument to mitigate political risk.
- Horizon Risk
The investment you made for the long term might need to be withdrawn before the expected time horizon in case of an emergency or urgent need of those funds due to reasons like loss of income.
The premature withdrawal might have a negative impact on the invested amount if it is withdrawn at low price when markets are down or if penalty fees is deducted from the amount as it is the case with some of the financial instruments. Most of the bonds and fixed income securities charge penalty fees for premature withdrawals.
The risk of facing unwanted losses or penalties due to withdrawals made before the expected time horizon is called horizon risk.
One need to plan for emergencies before investing so that this risk can be minimized.
- Reinvestment Risk
It is the risk of not being able to re-invest the principal or returns or the withdrawn amount at better rates due to the unavailability of a similar or better investment option. Financial instruments that have short maturity tenure or generate regular returns are prone to reinvestment risk.
This risk is common in Bonds or Bank deposits where the annual interest rate falls and investors has to reinvest the returns or principal at low rates every year.
To upkeep the buying power and enhance the value of the money earned after investment, it is important to reinvest the withdrawn or gained amount in a similar or better investment instrument.
- Third-Party Risk
Also known as counterparty risk, third party risk is the risk that is directly related to the broker or the investment manager. If the broker or the investment manager is unregulated, not qualified or licensed, it can be fatal for the investors as the counterparty can use the investment amount for self-interest.
Apart from this, if the investment manager follows an investment style that is not suitable for the investor, this will also incur third party risk as the investor might not be able to get suitable outcomes.
To mitigate the third-party risk, investors need to make adequate efforts to check the reviews, regulations, and licenses of the broker or the investment manager.
Like If you are investing in securities then you must check that your broker is authorized by NSE. While if you are investing in mutual funds you must ensure that fund manager is authorized by SEC.
In case you are trading forex, you must look for forex broker that is licensed with top tier regulators like FCA or ASIC or CySEC.
- Foreign Investment Risk
Investments made outside investor’s own country depend upon the market trends, economy, and currency fluctuations of the country in which the investment has been made. The local government policies, international policies and currency risks may affect the price movements of such investments & markets which often can be difficult to track for investors investing abroad.
For example – This risk impacts Nigerian investors investing in securities, forex or commodities abroad.
The risk of facing volatility in the investments due to foreign investments is called foreign investment risk. Investors should avoid allocating a large proportion of the investment amount in a foreign financial market or look for mitigating such risks through hedging, diversification and proper analysis.
Important: Review your existing investments & Understand Your Risk Tolerance
It is very important to understand all the risk elements that can affect your investment to ensure good & stable returns from your investments.
Investors must evaluate their existing investments to check what risks can affect them and ask themselves if they are comfortable taking these risks?
While making a new investment, investors should spend adequate time and effort in analysing all the potential risk factors in the chosen financial market & instrument and take the required steps to mitigate the risks with sound risk management strategies.
One must only invest if they can afford to take the concerned risks.