Investment risk is essentially the probability of loss relative to the return. The three main investment risks are market risk, interest rate risk and inflationary risk.
Investors are always struggling to define risk for themselves. Every investor is different and thus the risk is subjective. One investor may think that investing all their money in bonds is quite conservative. They forget that if interest rates rise, their bonds will surely lose. A lot of people do not understand risk and that is why they lose. They fail to ask themselves – how much loss can I tolerate?Â
The answer to this lies in your age. Age plays a very big role in assessing one’s risk tolerance. For instance, young people are able to withstand more swings in their investment portfolio than older people. This is because of the fact that they still have many years to recover. Older investors, on the other hand, are looking forward to retiring. Therefore, opt to preserve their investments and will only deal with inflation and interest rate risk.
The ultimate goal in building wealth is finding that perfect balance. The balance between the risk of losing money and the risk of losing out on great investment opportunities. Here are the main investment risks that we face as investors and how to plan against them:
Market Risk
Market risk is the type of risk that will affect all securities in the market, in the same manner. Therefore, it is caused by a factor that cannot be controlled through diversification of an investment portfolio. The risk arises from issues relating to the economic development or any other event that affects the entire market. In Kenya, we talk about factors like elections and the uncertainty of leadership. Investment risk encompasses interest rate risk, currency risk, and equity risk.
Currency Risk
Currency risk applies to foreign investments. The change in the price of one currency against another adds value risk to any foreign investments. As investors who seek to convert any profits made from foreign investments into Kenyan shilling may risk losing money. Therefore, if the Kenyan shilling is strong, the value of a foreign stock or bond purchased on a foreign exchange will decline.
For example, a Kenyan investor holding U.S stocks before the Uhuru-Raila handshake had a more valuable foreign asset relative to the Kenyan shilling. For every dollar in foreign asset held, the Kenyan investor gets about Kes 104. However, post-handshake, the shilling gained against the dollar, making the value of the Kenyan Investor’s foreign-held assets drop. Now, for every dollar in foreign asset held, the Kenyan investor would get about Kes 100 on conversion.
We can mitigate currency risk through hedging. This way, we limit the impact of exchange rate risk on foreign investments which erode returns from overseas investments. Rather than accept the numerous unknown risks associated with exchange rates, invest in hedged assets. You can also hedge yourself by using currency forwards, futures, options, and currency EFTs. For non-sophisticated investors, you can simply mitigate by investing for longer periods of time. This way, you give your investments time to level off.
Equity Risk
Equity risk is the possibility that an investor may lose money because of a drop in the market price of a share. The market price of a share varies due to the factors of demand and supply. Where a drop in the market price of a particular stock is as a result of a reduction in demand for that particular stock.
Take for example the case of Kenya Airways, the share price was at a low of Kes 4.65 last year in August. During this period in 2017, a lot of investors were selling the shares. Now the share price is oscillating between Kes 9 and 10 after a debt restructuring.
We can mitigate equity risk through diversification of the investment portfolio. This way we can limit the impact of the risk by protecting capital from wild market swings, while still achieving long-term growth.
Interest Rate Risk
The risks of a rise or fall in interest rates apply mainly to debt instruments such as bonds. The inherent risk is the probability of losing money because of a change in prevailing interest rates. For example, if the market interest rate goes up today, the market value of issued bonds will declines. The bonds will continue earning interest at their initial interest, making them unattractive to investors today. On the other hand, falling of interest rates affects investments such as savings and money markets – a drop in rates will result in lower returns on cash investments.
There are numerous ways to mitigate interest rate risk, however, the simplest way is to simply transition your portfolio weights from bonds to equity.
Inflationary Risk
Inflation erodes the purchasing power of investments over time if not kept in check. Cash investments in debt instruments are the most vulnerable. To do well, they must keep up or outdo market inflation to preserve capital. Therefore, any cash flow from these investments tends to decline as purchasing power decreases. Shares and real estate offer some protection, as when prices rise, companies and landlords increase their prices or rent.
The best way to deal with inflation risk is to invest in appreciable assets such as shares, real estate or convertible bonds. These assets have a growth component that stays ahead of inflation over the long-term.
Concentration Risk
There are some people who do not view this as a real risk but remember risk is subjective. Concentration risk is the probability of loss given that your money is all in one investment or type of investment. For example, the investor who puts all his/her money in a savings account or in bonds. When you fail to diversify, you fail to reduce your probability of loss. It is important to spread your risk over different investments and types of investments across industries and geographic locations.
Take Action
Since there is no such thing as a risk-free investment, review your existing investment portfolio. Assess the investment risk that affects your investments. From there, determine if you are comfortable taking on those risks and adjust accordingly to manage the risk.
Meanwhile, You can click on the following links to read more about building wealth:Â
