Risky Business: What Is Risk In Investments

Many retail investors do not understand risk well, though it is quite an important subject to understand for everyone. Risk drives how much one can invest and how much loss one can take. It also can determine the amount of profit one can potentially earn from an investment. With so much riding behind risk, it is important that every investor understands what it is and know how to manage it in their investment strategies.

There are many aspects to risk. Here are some of them.

Risk and reward go together

Stocks usually give investors higher returns over the long term than most other assets. However, stocks are also very volatile, meaning they are bought and sole at a high rate in the stock markets. If you own stock, you own a piece of the company. If the company whose stock you own goes bankrupt, you will lose all the money you have invested in that company. But if the company succeeds, you can get good returns and regular payments through dividends.

If you buy bonds, you get a regular interest from the bond issuer just like a loan. But bonds are also low-risk assets and bondholders don’t get paid much unless the company issuing the bond goes bankrupt.

This makes stocks a higher risk asset compared to a bond, because no matter what happens to the issuer, a bondholder will get their investment back, the same is not true of stocks. Since the risks carried by stocks are higher, the returns you get with stocks are also higher compared to bonds.

Sub-asset risks must be considered

Most investors only look at an asset class to decide risks. They think that stocks are riskier than bonds and that is the end of that conversation.

However, within stocks or bonds, some stocks will carry higher risk compared to others, and the same is true for bonds. Sometimes a stock may be less risky than a bond too.

Foe example, a small-cap stock may be riskier than a large-cap stock. A 20-year bond carries more risk than a 2-year bond. Risk works within asset classes as well.

Though bonds are generally less risky than stocks, a bond issued by a company with a bad debt rating, can be much riskier than a blue-chip stock.

Therefore, it is important for investors to understand the risk within assets before they decide to invest in any security.

Understand the difference between risk tolerance and risk capacity

Risk capacity is defined as the amount of money an investor can lose in an investment without compromising their financial status, or in other words, without losing all their money.

An investor who has a substantial amount of money in the form of savings, deposits, pension funds, rental income, salary, or business income, is said to have a high risk capacity, since they are able to rely on their available funds for financial needs and not tap into their investment income.

Risk tolerance, on the other hand, refers to the amount of risk an investor is willing to take and the amount of uncertainty about an asset that an investor is willing to factor in before making an investment.

While risk capacity can be measured by looking at a person’s bank statement, risk tolerance is a psychological trait in investors.

Probabilities are aplenty

The probability of the Indian stock markets falling more than 50% in a month are very low, but not impossible. Similarly, the probability of it growing exponentially is impossible, but not improbable.

While probabilities are a good way of measuring risk, they must be coupled with other factors before making an investment decision.

Market Risks Can Counter Diversification

No matter how diverse a portfolio is, the market usually has a mind of its own. Market risks can easily counter any diverse portfolio you can have to counter sectoral, geographical and asset risks.

For example, COVID-19 was a huge toll on the markets across the globe and no investor could have expected its impact on markets.

Every investor must factor in market risk before they make investment decisions.

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