- Date : 25/01/2020
- Read: 5 mins
We glibly talk of ‘market risks’, but how far do we really look at issues that lead to these risks?
Billionaire investor, Warren Buffett comes straight to the point when expounding on anything related to investments. Thus, on the issue of what constitutes a risk in investment, he is quite unambiguous: risk comes from, he says, not knowing what you are doing.
If you have just started investing, or are thinking of doing so, it would be worthwhile to take note of Buffett’s thumb rule: be aware of what you are doing. But to be able to do so, you must be able to identify those risks directly. They are of two types.
First, there is what is called systematic risk. This type of risk is not specific to the company you want to invest in. It is something that affects the entire market or even the industry that the company belongs to. Needless to say, the other type is just the opposite: It is company-specific or industry-specific and is known as unsystematic risk.
As an investor, you can reduce the unsystematic risks to your investments by diversifying your portfolio. This is possible because the factors that can affect one industry (and thereby, companies from that sector), may not necessarily affect another industry with the same set of factors.
However, this is not possible with systematic risk, which affects the entire market – a war, for instance. Therefore, this risk is sometimes termed an undiversifiable risk.
Let us flesh out the two categories in some more detail.
When we talk of “systematic risk”, we are basically referring to macroeconomic factors – natural, social, political or economic – that are likely to impact the entire market, and in turn, the returns on your investments in stocks.
Fluctuations in returns can be the result of changes in government policy, international developments, an act of nature such as a natural disaster like droughts and earthquakes, political and social upheavals and changes in the national economy.
Systematic risks, in turn, could manifest themselves through three broad avatars, these being:
- Interest risk: The RBI announces changes in the rate of interest from time to time, which can pose a risk for investors as rate fluctuations have a direct bearing on interest-bearing securities like bonds and debentures.
- Inflation risk: Rising inflation often limits the consumer’s buying capacity. This reflects in the bottom line of companies that adversely impacts their stock prices, thus posing a risk to one’s investment in those stocks.
- Market risk: This has been discussed earlier. Often, developments beyond the control of companies can affect the entire market. This, in turn, can take a toll on the shares one has invested in.
Often, some risks affect a particular organisation or a specific industry. This is known as unsystematic risk and can be divided into two categories: business risk and financial risk.
- Business risk: There is always the risk of a company not performing well, either due to internal issues like weak management, or external issues that may or may not affect that sector. This type of risk is known as a business risk. External factors that can that pose a business risk include:
- Changes in government policies
- Rise in competition
- Change in consumer taste and preferences
- Development of substitute products
- Technology upgrades leading to better products in the market.
All these can negatively impact the company bottom line, which can lead to a falling share price.
- Financial risk: Sometimes, the management of a company may undergo a change in the organisation’s capital structure, such as in its debt-equity ratio. This amounts to a financial risk, also known as leveraged risk.
There are ways to circumvent both systematic and unsystematic risks, though this is not always easy. For instance, systematic risks are caused by external forces that may not always be avoidable. Plus, these are generally beyond one’s control. However, such risks can be cushioned, through hedging and asset allocation.
On the other hand, unsystematic risks are easier to control through portfolio diversification as these are caused by internal factors.
But before everything, it is advisable to get a thorough understanding of a company’s fundamentals, including the background of the promoters before investing in it, and also understand the risks that it faces. For example, pharma stocks are sensitive to the policy announcements of drug regulators; it helps if you have some knowledge of the pharmaceutical sector.
So, if you as an investor have a clear insight into the state of the company and the sector it is in, you can reduce risks and make more money in the bargain. And that is why we all invest, right? To make some money? Knowing the important pointers before investing in the stock market will help you cut market risks substantially.