RISK in Investments

Investment decisions are a trade off between Risk and Return. Risk refers to the possibility that the actual outcome of an investment will differ from its expected outcome. Most investors are concerned about the actual outcome being less than the expected outcome. The wider the range of possible outcomes,the greater the risk.

SOURCES OF RISK
The three major sources of risk are:

• Business Risk
• Interest Rate Risk
• Market Risk  

Business Risk

As a holder of corporate securities (equity shares and debentures) you are exposed to risk of poor business performance. This may be caused by a variety of factors like heightened competition, emergence of new technologies, development of substitute products , shifts in consumer preferences, inadequate supply of essential inputs,changes in governmental policies and so on. The principal reason might be inept and incompetent management.

Interest Rate Risk

The changes in interest rate have a bearing  on the welfare of investors. As the interest rate goes up, the market prices of existing fixed income  securities fall and vice versa.This happens because the buyer of a fixed income security would not buy it at its par value or face value if its fixed interest rate is lower than the prevailing interest rate on a similar security. While the changes in interest rate have a direct bearing on the prices of fixed income securities, they affect equity prices too, but maybe indirectly. The changes in in the relative yields of debentures and equity shares influence equity prices.

Market Risk

Even if the earning power of the corporate sector and the interest rate structure remain more or less unchanged ,prices of securities , equity shares in particular, tend to fluctuate. Fluctuation is due to the changing sentiments of the investors. There are periods of when investors become bullish and their investment horizons lengthen. Investor optimism , which may border on euphoria during such periods drives share prices to great heights. The buoyancy created in the wake of this development is pervasive, affecting  all shares. On the other hand , when a wave of pessimism( due some political or economic bad news ) sweeps the markets , investors turn bearish and myopic. Prices of almost all equity shares register decline as fear and uncertainty pervade the market.

TYPES OF RISK

Modern Portfolio Theory  divides total risk as follows:

 Total Risk= Unique Risk + Market Risk

Unique Risk of a security represents that portion of its total risk which stems from firm-specific factors like the development  of a new product,a labor strike ,or the emergence of a new competitor.

Events of this nature primarily affect the specific firm and not all firms in general. Hence , the unique risk of a stock can be washed away  by combining it with all the other stocks. In a diversified portfolio ,unique risks of different stocks tend to cancel each other--a favourable outcome in one firm may offset an adverse happening in another and vice versa. Hence unique risk is also referred to as diversifiable risk or unsystematic risk. 

Market Risk of a security represents that portion of risk which is attributable to economy -wide factors like the growth rate of GDP, the level of government spending, money supply, interest rate structure and inflation rate. Since these factors affect all firms to a greater or lesser degree, investors cannot avoid the risk arising from them, however diversified their portfolio may be. Hence , it is also referred to as  systematic risk or non-diversifiable risk.