Assuming Mr. Osei takes a loan from Mr. Azumah at 20% per annum for the next 5 years to expand his business. By giving the loan, Mr Azumah is investing in Mr. Osei’s business with the hope that he will receive interest and his principal as promised. The possibility that Mr. Azumah’s investment will not meet that expectation is termed risk. In our everyday activities we are exposed to all sort of risks and the same applies to investments. Every investment has some level of risk. Unfortunately, we tend to focus more on the potential without understanding the potential loss that could occur. It is important to consider all risks you may be exposed to when investing.
There are two main types of risks associated with investment: systematic and unsystematic risk. Systematic risk is the risk that impacts the market as a whole e.g. inflation, changes in interest rates, cedi depreciation etc. This kind of risk is normally difficult to avoid and diversify. Unsystematic risk is the risk specific to a particular company or asset. In 2022, we witnessed a clear example of systematic risk fueled by the geopolitical tensions caused by Russian-Ukraine war and aftermath of COVID 19. Beyond these broad categories there are some other risks that may affect your investments.
Credit risk is the risk that a borrower will be unable to make the principal and interest payment on its debt obligations. Holders of bonds are exposed to credit risk due to the contractual arrangement. Normally government bonds have the least amount of default risk and hence should normally have the lowest returns. Corporate bonds tend to be more risky but also have higher return expectations. Currently, Ghana’s government bonds are exposed to credit risk due to government’s inability to fund its obligation hence the introduction of the Debt Exchange Program which is short of investor’s return expectations.
Country risk refers to the risk that a country won't be able to meet its financial obligations. This may adversely affect the performance of the country’s financial securities such as stocks, bonds, mutual funds etc.
Investing in foreign denominated assets or in a foreign country exposes your investment to foreign exchange risk. The investor needs to consider the effect of changes in currency exchange rates on the value of their investment. If you live in the Ghana and invest the US stock market or buy Eurobond or an asset priced in dollars even if the value appreciates, you may lose money if the US dollar depreciates against the Cedi.
Interest Rate Risk
Interest rate risk is the risk that an investment's value will change due to a changes in interest rates. When interest rates rise, the value of pre-existing bonds and other fixed income securities in the secondary market fall due to more attractive rates for new bonds thus increasing the opportunity cost of holding those. The opposite is true when interest rates fall. Bonds with longer maturities are more exposed to interest rate risk.
Liquidity risk is measures how easy it is for an investor to trade in their investment into cash. The more difficult it is, the more illiquid the investment is. For example, real estate is normally more illiquid than treasury bills. Investors will normally expect higher returns for more illiquid securities. Investors are normally advised to have some liquid assets as part of their portfolio so that they are not forced to sell illiquid assets at a loss.
Inflation is the general increase in the prices of goods and services or the fall in the purchasing power. Inflation risk is the probability that inflation will reduce the performance of your investment. One of the reasons for investing is to protect the purchasing value of your funds. When inflation high, it reduces or completely wipes of the real returns making investing less desirable.
As mentioned earlier, every investment has some level of risk associated with it. Normally investments with low risk have low potential returns and vice versa. In making investment decisions, investors must determine how much risk they want to take for a desired return. Factors like age, income levels, investment goals, liquidity needs, time horizon, and personality need to be taken into consideration. It is important to diversify your portfolio by investing in different asset classes to minimize risk.