Risk: Risk is the
uncertainty of an outcome, where both positive and negative results are
possible. In Border terms there are two types of Risk.
1.
Systematic Risk (Market Risk)
1. Market risk affecting the entire market.
2. Uncontrollable, impacts all companies, sectors, and
industries.
3. Influenced by broader economic, political, and
financial factors.
4. Cannot be fully mitigated but can be managed.
2. Unsystematic Risk
·
Definition: Risk specific to a particular company,
industry, or sector.
·
Impact: Unlike systematic risk, it doesn’t affect the entire market.
·
Mitigation: Can be managed through diversification.
Types of
Systematic Risks and Solutions to mitigate
1.
Interest Rate Risk (Central Bank Responsible)
When interest rates change by the Central Bank of Country, the value of
an investment can also change. This is called interest rate risk.
How to Mange Interest Rate Risk
·
Diversification: Spread your investments across different asset classes like stocks,
bonds, and real estate.
·
Floating Rate Securities: Consider investing in floating-rate bonds, which adjust their
interest rates periodically based on market conditions.
·
Investing in Growth Stocks: Growth stocks, often associated with companies reinvesting earnings
for future growth, may be less affected by interest rate changes.
Examples:
ü
Financial Sector: Banks (Increase Positive Impact) & Insurance Companies.
ü Real Estate: can increase borrowing
costs (IncreaseÂ
Negative Impact)
ü
Utility companies: Â Like electricity, Gas Water ( Increase Negative Impact)
2.
Inflation Risk
Inflation risk is the risk that the purchasing power of your money will
decrease over time. In simpler terms, it means that the same amount of money
will buy fewer goods and services in the future.
ü How is Inflation Measured in India?
The Reserve Bank of India (RBI) is responsible for measuring inflation in
India.
One of the primary measures is the Consumer Price Index (CPI). This
index tracks the average price of a basket of goods and services consumed by
households
To protect your investments from inflation, consider investing in:
1. Real Estate: Physical property like houses or commercial buildings.
2. Gold: A traditional safe-haven asset.
3. Equities: Stocks of companies with strong fundamentals and pricing power.
4. Commodities: Commodities like oil, gas, or agricultural products.
5. Inflation-Protected Securities: Securities like TIPS designed to protect
against inflation.
3.
Market Risk (Equity Risk)
The risk of losses due to declines in the
stock market, driven by macroeconomic factors like recessions or geopolitical
issues.
Example: During the COVID-19 pandemic, stock markets globally fell as
investor confidence dropped.
To protect your investments from Market
Risk
– Diversification
Across Asset Classes: Hold a mix of equities, bonds, and cash to reduce the
impact of market downturns.
– Hedging: Use options, such as buying put options, to protect against
declines.
– Invest in Defensive Sectors: Sectors like healthcare and consumer
staples tend to be less affected by broad market declines.
4.
Exchange Rate Risk
The risk of
financial loss arising from fluctuations in foreign exchange rates.
Example: A U.S.-based investor in European stocks may see returns
affected by changes in the USD/EUR exchange rate.
To protect your investments from Exchange Rate Risk
– Currency-Hedged Investments: Consider hedging currency exposure by
using currency-hedged funds or derivatives.
– Invest in Domestic-Focused Companies: Focus on companies with minimal
exposure to foreign currencies.
– Diversify Across Currencies: Spread investments across multiple
currencies to reduce dependence on one currency.
5. Political and Geopolitical Risk
Risks of
financial loss arising from political instability, policy changes, or
international tensions that may affect global markets.
Example: Trade
tensions between the U.S. and China in 2018 impacted technology companies with
global supply chains.
To protect your investments from Exchange Rate Risk
– Global Diversification: Diversify investments across multiple
countries to avoid over-reliance on one political climate.
– Invest in Defensive Sectors: Sectors like utilities and consumer
staples often perform better during geopolitical instability.
Unsystematic Risk
·
Definition: Risk specific to a particular company,
industry, or sector.
·
Impact: Unlike systematic risk, it doesn’t affect the entire market.
·
Mitigation: Can be managed through diversification.
Types of Unsystematic Risks and Solutions
1. Business Risk
Description: The risk associated with the
individual operations and financial health of a specific company.
Example: If a company loses its market
share due to poor management, it may experience declining stock prices.
Solutions:
– Conduct Thorough Research: Analyze company financials, management
quality, and industry positioning before investing.
– Invest in Well-Established Companies: Larger companies with stable
earnings often carry lower business risk.
– Diversify Across Companies: Reduce exposure to individual companies by
spreading investments across multiple stocks.
2. Financial Risk
The risk that a company may fail to meet
its financial obligations due to high debt levels or poor financial management.
Example:
During the 2008 financial crisis, companies with high leverage, like Lehman
Brothers, faced liquidity issues and eventually collapsed.
Solutions:
– Evaluate Debt Ratios: Invest in companies with manageable debt levels
and strong cash flow.
– Avoid Highly Leveraged Companies: High debt increases the risk of
default, especially in economic downturns.
– Monitor Financial Health Regularly: Continuously assess the companyÂ’s
financial statements to stay updated on any signs of financial distress.
3. Liquidity Risk
The risk of not being able to sell an asset
quickly without impacting its price. Low trading volumes can make certain
stocks illiquid.
Example:
Small-cap stocks or shares in private companies often have lower liquidity than
blue-chip stocks, making them harder to sell at a desirable price.
Solutions:
– Invest in High-Volume Stocks: Focus on stocks with high trading volume
to ensure easier buying/selling.
– Limit Exposure to Illiquid Assets: Avoid allocating a large portion of
the portfolio to illiquid investments.
– Plan for Longer Holding Periods: If investing in low-liquidity assets,
prepare to hold them longer if necessary.
4. Operational Risk
Description: Risks arising from internal
issues within a company, such as technical failures, employee errors, or
inadequate processes.
Example: Knight CapitalÂ’s software glitch
in 2012 led to a $440 million loss due to a trading algorithm error, eventually
forcing the company to seek outside assistance.
Solutions:
– Evaluate Operational Efficiency: Assess companies for strong operational
controls and quality management practices.
– Use Reliable Trading Platforms: Choose established brokers with robust
security and reliable platforms.
– Conduct Periodic Reviews: Regularly evaluate and adjust investments to limit
exposure to companies with potential operational risks.
5. Regulatory and Legal Risk
Description: Risk of financial loss due to
changes in laws, regulations, or litigation involving a company or industry.
Example: In 2018, the tobacco industry
faced regulatory risks as several countries increased taxes and implemented
advertising restrictions on tobacco products.
Solutions:
– Monitor Industry Regulations: Stay updated on regulatory changes that may
impact investments.
– Diversify Across Sectors: Avoid concentrating investments in highly regulated
sectors to reduce exposure.
– Focus on Companies with Strong Compliance: Invest in companies that are
proactive about regulatory compliance.
Comparison of Systematic and Unsystematic Risk
|
Aspect |
Systematic Risk |
Unsystematic Risk |
|
Impact |
Affects the entire market or economy |
Impacts individual companies or sectors |
|
Management |
Cannot be eliminated, only minimized |
Can be mitigated through diversification |
|
Examples |
Inflation, interest rate changes, geopolitical events |
Business failure, poor financial management, regulatory issues |
|
Solution Strategies |
Diversification across asset classes and hedging |
Diversification across stocks and industries |