Investing requires us to choose between eating well and sleeping well. If you want to eat well, be ready to take on the risks involved in seeking higher returns. If sleeping well is what you are more concerned about, be ready to give up higher returns in exchange. But in either case defining risk only in terms of the probability of losing money is not enough. Risk comes from various sources, so it is important to understand the different types of risks that come to the fore while picking an investment.
Financial risk :
Interest being tax-deductible, equity shareholders welcome debt to the extent it enhances their returns. But beyond a point, they are exposed to the risk arising from a high level of fixed commitments. This describes financial risk. It arises when debt represents a higher proportion of a company’s capital structure (comprises net worth and debt).
Exchange rate risk :
This is the risk arising from changes in exchange rate of the rupee versus the US dollar or any other currency. Profits of companies who import a relatively large part of their raw material are at risk if they are not able to fully pass on cost increases when the rupee depreciates. A weakness in the rupee also prompts foreign investors to withdraw from the stock market by selling their shares and converting those rupees into dollars. While they may re-enter at lower levels, that stock indices tumble in the short-term is a big risk for the domestic investor.
Industry risk :
It is the risk applicable to an industry. A large scale shift in demand, a rise in input prices, regulatory changes are typical factors that would signify such a risk. For example, a shift in demand for generic medicines compared to innovator drugs would pose a big threat to big pharmaceutical majors globally. Or, a shift in trucks from single-axle trucks to multi-axle trucks will pose a major threat to companies unable to produce the new type of trucks.
Inflation risk :
Inflation can hit a company’s profits if it is unable to pass on higher costs to consumers. This trouble is often faced by large manufacturing concerns and public sector units through wage hikes that occur due to inflation. They are not easy to pass on. Even if inflation eases, wage hikes can rarely be rolled back. Worse, inflation can inflate corporate profits through overvaluation of closing inventory. When a company uses the FIFO (first in, first out; where the material that is issued first is priced on the basis of the cost of material received earliest) method to value inventory the charge to production is low in a period of rising prices. This can inflate reported earnings, increase tax burdens and may prompt a higher dividend—consequently the company is financially weaker.
Interest rate risk :
Since they come with a fixed return, bond values fluctuate with changes in interest rates. When interest rates rise, the value of an existing debenture goes down, as it is paying a lower rate than what investors could earn elsewhere. When interest rates fall, the value of a debenture rises as they are now earning a higher rate than what investors could earn from one that is newly issued. The longer the maturity of a bond, the greater is its vulnerability to an interest rate risk.
Management risk :
It is simply defined as the inability of the management to take decisions in the larger good of its minority shareholders and the company. All decisions that benefit only a company’s directors and its promoters would classify as a management risk. But even a shareholder-friendly management can be a risk if it is unable to manage a company’s growth in both good and bad times or if it lacks the dynamism needed to lead a company.
Business risk :
It is the variability of a company’s earnings before interest and taxes (EBIT). It is a combination of the following: one, change in demand. If demand for a product/service is not stable or predictable, its revenue won’t be stable or predictable either. Next is the company’s ability to increase prices or absorb cost increases, which is crucial to sustain profitability. Companies differentiating their products through branding are better equipped to pass on cost increases and earn above average profits. Third, if fixed costs are a substantial portion of total costs, business risk is definitely higher (unless such a cost also creates a strong entry barrier) since a company’s earnings then are more susceptible to variations in demand and prices.
Market/Economy risk :
Risks that are common across companies are known as market/economy risk: economy-wide factors like money supply, level of government borrowings, changes in industrial policy, a global recession and so on. It is also known as non-diversifiable risk, since investors cannot avoid the risk arising from them, however diversified their portfolios may be.