If you are an investor, you are aware that an investment is made with the goal of increasing the value of your money through a return on investment. If you are a docile investor, you will always prefer investments with a fixed rate of return, such as fixed deposits in banks or post offices. And if you are an aggressive investor, you will want to invest in stocks and shares of companies that are high risk but have the potential for a higher return in a shorter period of time.
Regardless of which category you fall into, a prudent and well-calculated investment will yield a good return.
Depending on the level of risk involved, you may be classified as one of the six risk factors listed below:
Interest Rate Risk
This is a type of risk in which, as interest rates rise, the value of the fixed-rate debt instrument may fall. If you purchase securities with a fixed rate of return, such as bonds and preferred shares or stock, the bond's price will fall as the rate of interest rises. This risk also exists when interest rates fall, because bonds that mature or are paid off before maturity must be reinvested at a lower yield.
Credit or Default Risk
This type of risk may arise if the bond issuer fails to meet the anticipated rate of interest or principal repayment. The higher the bond's interest rate, the greater the credit risk. This type of risk is related to the company's debt-equity ratio. If the debt exceeds the desired ratio, and the company does not perform well, it may be unable to meet its financial obligations to bondholders. In the worst-case scenario, the company may be unable to repay the principal as well.
Business Risk or Unsystematic Risk
This type of risk is associated with a specific Security issuer. In general, every business in the same industry faces the same types of business risks. The business risk arises in particular if the bond or stock issue goes bankrupt and thus fails to pay the guaranteed rate of interest or even the principal. To protect against such unforeseeable events, it is best to invest in funds that use diversified investing, holding securities from various types of companies.
Call Risk
This type of risk arises when debt securities are called back before maturity. This risk leads to reinvestment risk. In this case, you must seek out an alternative investment that will provide you with the same level of income while exposing you to the same level of risk. When interest rates consistently fall, call risk arises. This is because the company will redeem bond issues with higher coupons and replace them on the bond market with bonds with lower interest rates. In such a case, you may have to take on more risk in order to replace the same stream of income.
Inflationary Risk or Purchasing Power Risk
When inflation causes the country's currency to devalue, a situation may develop where the value of an asset or income is diminished. In this type of risk, future inflation will reduce the purchasing power of an investment's cash flow, to put it the other way around. When the cost of living rises along with the prices of goods and services due to inflation, your purchasing power decreases. If you have cash, savings, or bonds on hand, you will be at danger in this way. Such assets won't increase in value over time to help you achieve your long-term financial objectives. Your investment will lose value due to the risk of inflation. Consequently, make substantial stock or convertible bond investments.
Liquidity Risk
As a result of the restricted options, you might not be able to acquire or sell an investment when you want to or in large enough amounts. A good illustration of a liquidity risk is selling off real estate. The real estate cannot be sold as-needed, unlike government assets or reputable stocks.
You need to decide for yourself which category you belong to in light of the concerns already discussed.
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