7 Portfolio Risks Investors Cannot Afford To Overlook

7 PORTFOLIO RISKS INVESTORS CANNOT AFFORD TO OVERLOOK

Any investment portfolio is exposed to multiple risks at any given point of time. 

It is essential you understand these risks before you make any major investment decisions.

Here are seven of the risks investors cannot afford to ignore...

INTEREST RATE RISK

Interest rate fluctuations impact the value of fixed income bearing instruments.

Suppose you have invested in a security yielding 9 per cent return for 5 years. If interest rates move up to 10 per cent in a year, fresh securities issued at the new rate will be in demand while the value of your security will fall. 

Higher the tenure, higher the interests risk.

Managing this risk 

Align the instrument maturity with your investment horizon—short-term bonds for up to 1 year horizon; medium-term for longer.

DEFAULT RISK

This arises from the possibility of nonpayment of principal and interest by the issuer of fixed income bearing instruments.

Investments in company FDs, NCDs and debentures are exposed to it.

However, government-backed instruments carry no default risk.

Managing the risk 

Opt for AAA and AA or equivalent rated instruments which carry the lowest risk. Lower rated instruments yield higher return, but carry much higher risk.

MARKET RISK

It is the risk of undesirable changes in the value of your investment due to factors affecting the financial markets as a whole.

Both stock and bond markets are exposed to this risk of rising and falling prices.

This requires you to time the entry in the investment.

Managing the risk 

Market risk can be mitigated by diversifying among asset classes as well as individual instruments whose movement has little correlation with each other.

REINVESTMENT RISK

This risk arises from the possibility of interest rates declining when your existing fixed income instrument matures or comes up for renewal or there is a cash flow from the instrument.

In this scenario, you will have no option but to reinvest at the prevailing lower rates. Zero coupon bonds are the only fixedincome instruments to have no reinvestment risk.

Managing the risk

Taking reinvestment risk into account is critical during a softening interest rate environment. The risk can be mitigated to some extent by investing in instruments across various maturities.

INFLATION RISK

Refers to the possibility of rate of return from investments not keeping pace with rise in prices, leading to erosion of invested capital.

Relatively safe bank deposits and small savings schemes are more exposed to this risk as rising prices can eat into purchasing power of invested capital.

Managing the risk 

Invest in avenues that have inherent potential to beat inflation on a sustained basis. Equity remains the best asset class.

CURRENCY RISK

If your portfolio includes investments in international funds or global stocks, then it is exposed to currency risk.

The fluctuations in the rupee-dollar exchange rates can impact the returns. If your investment fetches 10 per cent return in a year in dollar terms, 5 per cent depreciation in the rupee in the interim will enhance the rupee-denominated return to the same extent.

A 5 per cent appreciation, on the other hand, can eat away that much.

Managing the risk

This risk can be harnessed to play on currency movements. For instance, if you believe the rupee will depreciate against the dollar over the next few years, investing in a global fund will enable you to gain from this movement.

LIQUIDITY RISK

Any investment should not only be profitable but also provide liquidity. It means ready availability of money, should you require it.

Liquidity risk refers to possibility of the investor not being able to convert investments into cash, or realise the value of investments when required.

Managing the risk 

Keep a portion of investments in liquid avenues like MFs or bank FDs. Large-cap stocks are more readily sale-able than mid- or small-caps.

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 Bibliography:

1. Economic Times

2. Google

3. other websites