Every investor expects higher return from the risky investment as likened to less risky investment. For assuming higher risk there should be high premium rather then less risk. In each and every kinds of investment, certain level of risks are associated.
The degree of return depends upon degree of bearing risk by the investor. High risky investment opportunity should produce high return. Likewise, less risky investment opportunity should produce less return. If so, investor would be awarded by appropriate incentive as per degree of taking risk.
Investor can not skip the risk associated with investment. Though, a rational investor could minimize the risk by assessing factors of risk allied with investment. Investor shall have to appropriately analyze internal as well as external factors of risk before captivating decision of investment.
Total risk is the sum total of non- diversifiable and diversifiable risk of scenarios. Standard deviation is an absolute measure of risk and is calculated as the square root of variance.
Risks To Understand While Making Investment Decision
1. Business Risk
Before making any investment decision, a rational investor shall have to analyze the risk associated with the business. Return on investment depends on profitability of business. Profitability of business depends on quantity of sale of goods and services. Quantity of sales depends on demand of goods and services, quality and quantity of goods and services, price, market, substitute goods and services and so on.
Before investment in the share and debenture of a company, investors shall have to predict the viability of business. How long will the business run? What is the demand of goods and services offered by the company? Who are the competitors of a company? And so on.
Suppose, several hydropower companies are established and going to generate the power/electricity. In this context, what would be the future prosperity of petroleum related business. Investors should seek out the most considerable questions regarding on the investment in petroleum business. Whether to invest or not? Whether to invest for long run or short run? That has to be answered by investor himself/herself and take the decision for investment.
A rational investor shall have to judge out risks associated with business prior to investment in share and debenture of such a company.
Government priority, perception and support, tax policy, government rules and regulation, regulatory support, demand of goods and services, competitors, substitute goods are very basic factors to be considered to judge the business and its risks prior to investment.
Government increasing tax year by year to liquor industry and discouraging to people to consume such a product. Whereas government provides different kind of subsidy to agriculture industry and play supportive role too. Which directly influence the future prosperity of business, possibility of long run, size of profitability of business and rate of dividend and market price of share and debenture.
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2. Financial Risk
Company finance their assets by both equity and debt capital. Equity capital means the capital invested by promoters themselves from their pocket. Whereas debt capital is a capital which is borrowed from BFIs. For this, the company should have to pay regular installment to discharge the debt within prespecified time. Thus, huge portion of cashflow of company may use to pay installment to BFIs, if the portion of debt is higher than equity.
A rational investor should have to observe the components of capital which is depicted by the statement of assets and liabilities of a company. Debt- equity ratio is used to analyze financial risk by investors. A high debt-equity ratio indicates higher contribution of creditors towards total financing of the company. If so, major portion of profitability of the company shall use to pay interest to the creditors, which minimizes the return to investors in terms of dividend. Similarly, if the company is unable to satisfy fixed claimed on time, it may become insolvent or bankrupt.
Therefore, a company using borrowed capital experiences additional risk known as financial risk- inability to cover fixed obligatory payments. Company should maintain well structure of debt and equity. If company use only equity there is risk/loss to company because company has to pay more income tax to government and cannot enjoy tax benefit.
More debt of company is more risk to investors. So, prior to investing in share and debenture of a company, one should have to appropriately appraise the balance sheet of company.
Debt equity ratio can be calculated dividing by total equity of company to total debt of company.
3. Purchasing Power Risk
Purchasing power risk is the risk caused by the change in general price level in the economy. This risk is related to the inflation. At least, rate of return from investment shall have to be greater than inflation. Specifically, before investing in debentures (fixed income security), the investors has to keenly evaluate the trend of the inflation. The maturity period and interest rate of debenture is fixed already. Whereas, inflation rate is changeable and can not be predicted . So, there is always risk of inflation rate compared to interest rate in debentures. Today’s Re.1 is more worthy than tomorrow’s Re.1, so we should focus on today’s purchasing power.
Supposed, at present Rs. 100,000 has been invested in debentures having maturity period 10 years at 8.5% coupon rate. This rate is fixed till maturity period. But, inflation rate in economy is 9% since 5th year of the investment. Here, purchasing power of our investment from 5th year of investment will decrease as compared to the beginning years of investment because of rate of inflation.
Investment in common stocks is less exposed to purchasing power risk because the rate on common stock investment generally follows the inflationary movement in the economy.
4. Interest Rate Risk
Interest rate risk arises due the change in market interest rate. It is the risk that the value of an investment may adversely be affected due to the change in interest rate in the market.
There is inverse relation between bank’s interest rate and security prices. If interest rate is increased in market, at that time prospective investors shall divert their fund in to BFIs rather then investing into securities. If bank provides higher interest on deposit, investors invest/deposit their money in to bank for good return rather then investment in stocks. This is less risky than investment in shares and debentures.
On the other hand, if the interest rate of bank is lower in market, then investors withdraw deposit from bank and invest their money into shares and debentures for higher rate of return.
There are two aspects of interest rate risk i.e. maturity risk and reinvestment risk. Maturity risk is common for long-term securities. However, reinvestment risk is associated with short-term securities that is because of decline in market interest rate.
There is inverse relationship between bond price and interest rates. As interest rate rises, bond prices fall, and vice versa.
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5. Liquidity Risk
Liquidity risk is associated with marketability of stocks/securities. A rational investor shall always invest their fund into those securities which are highly saleable in market at any moment at the reasonable price.
Due to unfavorable market scenario, the company may face liquidity crunch. If so is the case, there is risk of dividend payment in case of investment in common stocks. Likewise, there is risk of interest and principal in case of investment in debentures/bonds.
If the company face liquidity problem, company could not discharge its liability on time. Similarly, company could not provide cash dividend to its investors and interest to the creditors. If the situation is worse, the company may dissolve.
So, a rational investor should appropriately appraise the performance of company, directors of company, financials of the company, market conditions and scenarios of the company to secure their investment before actually undertaking investment.
6. Market Risk
Market risk is very influential risk. The company can not control and manage such kinds of risks. The company should learn to change itself as per changes in the market to survive. Such risk structures are macro risk structures that influence overall market scenarios.
Political events, socio-economic changes, legislative changes, changes in government’s fiscal and monetary policy, changes of customers tests and preferences, changes in technology, nature of market competition, and so on.
Security market is very sensitive market, a small rumor can adversely affect it. An investor should properly appraise such market risks for the rationally investment.
(Mr. Mukunda Tripathee is a Banker.)
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