Risk is something which a person would hold himself back before undertaking some action, whether it is investing or doing some activity. There are people who have distinctive character traits, they could be risk takers and risk averse or we can say they are conservative investors. When an investor takes his first step towards investing, he should be aware about the risks involved while investing.
Considering the volatility in the market, there is a possibility of people gaining value for the money. In last 10 years it has been a roller coaster ride for investors, but apart from volatility we have seen lot of opportunities in the market. Those who have stood strong i.e. being unemotional in their investment philosophy have made lot of money, despite of number of risks. The Investment habit, the discipline and the philosophy if maintained would lead to achieve your goals.
If we see presently there are so many investment products and vehicles which a person can invest in. Equity being a risky asset, an investor has the option to keep aside little corpus in debt products diversifying the risk considering the investment horizon and risk appetite. An investor has lot of options with him to make value investment by allocating part money in both instruments. Before a person starts investing he needs to understand the basic risk factors involved.
We have come up with various kinds of risks which you should know before building up your portfolio:
To start with we have two types of risks involved:
- Systematic Risk
- Unsystematic Risk
Systematic risk is also called as “Undiversifiable risk”. It reflects the market wide factors such as country’s rate of economic growth, corporate tax, interest rates etc. There is very little you could do about this risk. It includes all of the unforeseen events that occur in everyday life which are beyond the control of investors. Since the exposure is wide each person would get affected by this risk. Systematic risk is involved in each portfolio. Since some investments are highly prone to several market factors they get affected the most and have higher systematic risk.
For E.g.: If we take one sector like Infrastructure, it is directly related to interest rates because they are highly leveraged companies. If interest rate goes up all companies would be affected in the same manner. Similarly the power sector or automobile sector is dependent on Crude Oil prices. if there is one event happens the whole market gets affected.
Under Systematic risk there are 3 risks which are as follows
- MARKET RISK
- INTEREST RATE RISK
- PURCHASING POWER RISK
SO WHAT IS MARKET RISK?
When we talk about market risk, it’s a type of risk which occurs based on the happening of the real events and reactions of investors in similar way. So, in a way when the event occurs the investors would react in a positive or negative way depending on the event. An industry or a sector would be hard hit when the industry goes out of fashion. There is each cycle which each market goes through. Your question would be which are these cycles? These cycles are themes which this market would ride on.
For E.g. Let’s take an example of two phases 1900’s and 2000’s compare how market risk would affect a portfolio. In 1900’s we had manufacturing industries like Reliance Industries which had done really well. These stocks are called “old economy stocks”. Suddenly these stocks went out fashion and it led to contraction in PE multiple. These stocks became undervalued and no one was ready to buy this stocks as there was not much growth left in that stocks. Then came the “new millennium stocks” which came in early 2000. It consists of IT stocks like Google, Apple or Facebook have turned their fortunes well by investing rightly and PE multiples are expanded dramatically. If we compare IT companies with manufacturing companies, the latter would command lesser PE multiple since they are out of fashion. These explains the “market risk”.
We have another risk which is “Interest rate risk
” which is also a type of systematic risk. If interest rates increase cost of borrowing would increase therefore companies with higher leverage would be affected the most.
E.g.: If we consider infrastructure or banking stocks, they are highly leveraged stocks and once the interest rates are high, cost of borrowing would be high and eventually more and more cash would go out in a form of finance cost would increase having a direct impact on the margins, reducing its profitability leading to deterioration in stock prices and lowering of dividends since there would be default in payments.Here is a catch when lending institutions lends money they would enjoy revenues for quarter or two until the interest rate are low, when the interest rates grow the revenue stops coming in as the borrowing company would not have sufficient money to service the debt leading to defaults in payments that could lead to Non Performing Assets’s for lending companies and then affect them negatively. Best example is the Public-sector Banks which are Non Performing Assets’s ridden.
Unsystematic Risk is a portion of total risk that is unique or peculiar to a firm or an industry above and beyond that affecting securities in general. It is called as specific risk, diversifiable risk. It affects a industry or a company or an industry.
For E.g.: Strike at a Tata Motors Plant would affect only Tata Motors company unlike the whole sector as it is “Unsystematic risk”. Another example is of Telecom Sector. We have companies like Idea, Airtel, Reliance Communication, Tata Communication which comes under one sector. The regulatory authority states that all companies are supposed to pay higher licensing fee which, this would affect the whole sector and not one single company.
Certain Factors could cause unsystematic risk such as:
- Management capability
- Consumer preference
- Labour strikes
Under Unsystematic Risk there are two heads:
- Business Risk
- Financial Risk
The Business risk is divided into 2 broad categories:
I. Internal Business risk:
it is a type of risk which is largely associated with the efficiency with which the firms undertakes its operations.
For example, Tata motors had come up with Tata Nano and built a plant in West Bengal. Due to some problems regarding labour it had to shift its plant to Gujarat. This incurred lot of cost to the company and it was specific. This is called Internal Business risk.
II. External Business risk: It’s a result of operating conditions imposed on the company by circumstances beyond its control. It’s very different from Systematic Risk as it’s situational based.
For example, if there was competition in Telecom sector, competition in the telecom sector has led to drop in the margin due to more and more players entering the market leading to decline in Average Revenue per User (ARPU). There is a change in the tariff plans leading to acquiring more customers and not making money rather than making more money and losing customers.