Types of Risks in an Investment - Essay Example

Risk assessment Student’s Name: Instructor’s Name: Course Code: Date of Submission: Introduction Many organizations in the global business are concerned with the way they can gain competitive advantage through risk management. Among the best performing global companies, it can be noted that risk management has been given a priority and they have been able to mitigate on the risks. It helps to utilize resources effectively as well as avoiding interruption in the manufacturing process. For instance, through risk management an organization can be able to forecast on the changes in the supply market and take necessary precautions to avoid stock outs in case the supply will decline. In this regard, it could have avoided risks which could have otherwise affected the production process (Andy & Simon 2013). Therefore, risk management is important to any organization as it improves the performance of an organization and also improves the competitiveness. In this regard therefore, this paper will discuss what risk is, diversifiable and non diversifiable risks, types of risks, ways of managing risks and importance of risk management to an investment A risk is when there is a probability of loosing some benefits by an organization that lead to lack of provision to an investment (Andy & Simon 2013). Risks affect the whole process of an organization and the returns on the investment are not achieved. Risks are measured by observing directly and mathematical models can be used to measure risks. Risks can be classified into two broad categories namely the diversified risk and the non diversified risk. Diversified risk is the risk which is associated with the general market changes. It is a risk which is specific to a certain sector hence its diversification portfolio is limited. An example of this risk is losing market share (Andy & Simon 2013). This will affect the real company and not other companies hence there is decline of investment in that company. On the other hand, non-diversifiable risk can be defined as a risk which can be general to whole property or assets. The value of the investment can decline when there are changes in the economy which affects larger sectors of the market. It is also called systematic risk (Andy & Simon 2013). It is the risk which is associated with individual investments and it affects the whole investment. This is because of the uncertainty and changes in the market conditions. Types of Risks in an Investment Types of risks in an investment There are various risks which can affect the return on an investment. If these risks are not properly managed, they can affect the overall performance of an investment. Discussed below are some of the risks which can be encountered by an investment. Non-diversified risks The first one is the credit risk. This is the risk which is associated with the inability to pay the principal or the interest rates. For instance, if an investment is promising to pay an interest rate of 12.5% instead of the usual interest rate of 9%, then there is high chances of credit risks. This because the organization may not be able to pay that interest hence there is credit risks. Credit risk increases the debts by an investment thus may not be able to achieve its set objectives (Jonathan & Niklas 2012). Interest rate risk is another risk associated with an investment. This is the changes in the prices of interest rates. When there is a change in interest rates, the impact goes into bonds. There is always a relationship between the prices of bonds and the interest rates (Jonathan & Niklas 2012). When there is an increase in the interest rate, the bond prices will go down and when there is a decrease in interest rates the prices of bonds go up. This risk affects the investment because an investor may not achieve the target due to changes in interest rates. There is also another risk called liquidity risk. This is the risk associated with the sale of bonds. When there is need to sell the bonds due to immediate requirements and the customers are few, the bonds may be sold at a discount so that they can be sold (Arvind 2006). This is a risk to any investment because the bonds might be sold a price lower than they were purchased because of the immediate requirements. In this effect, the investor may not get back the expected returns from the investment. In addition, there is an exchange rate risk. This is the risks which is very common when there is international trade or international investment (Jonathan & Niklas 2012). For example if an investor invests in the US and earn about 9% in the year, the following year the investment returns may go down if the US Dollar loses value by 1%. Therefore this becomes a risk to an investor because he or she may lose the investment returns if the Dollar will continue loosing value while other currencies will be gaining value. Moreover, there can be a political risk to an investment. This is the risk associated with change in the government policies. An investor can make an investment but after some time the government changes its policies (Jonathan & Niklas 2012). This will greatly affect the performance of an investment. For instance, there might be an investment in sugar factory and the policy of the government is that local products are given priority. This can lead to better performance of the company but if there is a change in government policy to outsource sugar products, this will be a great danger to the investment and it might be closed down. Therefore, political system can be a source of risk in an investment. Diversified risks Management risk - this is the risk which is associated with poor management decisions. It is all about the internal aspects (Andy & Simon 2013). It is also known as company risk. When the management makes poor decisions or poor forecasting, the effect is that the investment may not cope up with the external environment thus the investment returns will be low. Information risk can further affect the investment return. This is when there is an investment made based on the information gained for example through an advertisement (Andy & Simon 2013). The information may turn out not to be true and can greatly affect the performance of the investment. For instance, when there is an advertisement of a bank loan it may show interest rate of 9% but the real interest rate is 14%. This information can be misleading thus can affect the investment decisions. Furthermore, there is market risk. This is the risk associated with market changes for instance changes in the price of products or services. This risk is more common to stocks and options. When the prices fluctuate negatively, the investment is affected and low returns are made but when prices fluctuate positively an investment gain (Andy & Simon 2013). The investment can generate higher income from the sale of products and services. Therefore, in a higher volatile market the probability is that an investment can increase or decrease. Ways of managing investment risks Investment risks can be managed despite some of them being uncertain. There are measures that can be put in place so that the risks can be avoided. Discussed below are some of the ways of managing the investment risks. The first strategy is to avoid risks. Risks can be avoided because the investor has the option to select the most appropriate investments (Anne & Sylvie2012). Some investments are more prone to risks than others thus selecting an investment which is less risky can enable the investor to avoid risks that might affect the performance of the investment. In doing this, the investor selects investments which are and guaranteed hence avoiding risks. Another way to manage risks is by diversifying the risks. Risks associated with an investment can be diversified by spreading the investment into various sectors (Andy & Simon 2013). When one sector is affect by the investment risk, the other sectors can uplift it and restore the investment into its original position. Unlike when the investment is not diversified, the chances of investment being affected by the risks are high. Therefore, it is important to assess the various options available for diversifying the risks and their limitations and then select the most appropriate one to help in diversifying the risks. Investment risks can also be managed by taking calculated investment risks. This is the strategy that enables the investor to think, have knowledge and research in the area of the investment. This helps the investor to understand how various markets operate and the risks associated with the kind of the investment (Andy & Simon 2013). There are some investments which attracting but they have the highest risks. For instance during bank loan promotions, the interest rates may seem to be low but in the real sense the interest rate is too high when repaying the loan. This is the risk associated with the information. Therefore, it is important to collect clear and accurate information before making an investment decision which avoids risks. In addition, insuring against investment risks is another option for managing the risks. Investments can be insured against risks which are uncertain (Andy & Simon 2013). There are various types of insurance covers which can help in managing the risks once they occur. For instance, an investment can be insured against fire and theft. This will help to manage the risks once they occur because the investor will be compensated. The compensation is meant to restore the investor into his or her initial position. Furthermore, investment risks can also be managed through engaging in investments which are protected from inflation. For example in the US, there are securities which are protected against inflation like the Treasury Inflation Protected Securities (Andy & Simon 2013). With this kind of investment, there is an assurance that the performance of the business will be good because they will not be affected by inflation. It is easier to manage other risks considering the above strategies hence the investment is likely to perform well in and avoid risks. To manage the interest rate risks, an investor should consider the investments which have fixed income securities. This will enable the investment to avoid the risks of fluctuating interest rates which could otherwise affect the investment returns (Andy & Simon 2013). In addition, bonds with shorter maturity periods have less risk when they are compared with bonds with longer maturity periods. This is because with a longer maturity period, chances are that the market can change leading to changes in the interest rates. Interest rates do not easily affect bonds with shorter period of time. Investment risks can also be managed by following up the trend in the market. This means that an investor should consider the investments which are currently excelling in the market (Anne & Sylvie2012). This will help the investment to be relevant unlike taking up investments which have been exploited. This helps to reduce the operational risks which could be associated with saturation of the industry. Importance of Risks management Risk management is important for any investment. Without management of risks, there are high chances of the investment not performing well which can lead to low investment returns. The following are some of the reasons why risk management is important to an investment. It helps to avoid unwelcome surprises. Through risk management, an investor is able to forecast on the likelihood of risks thus come up with strategies to avoid them (Quan Li 2006). Risks lower the performance of an investment therefore it is important to set strategies that help the investment to avoid them thus avoid unwelcome surprises. Risks also help to improve the utilization of resources. By forecasting on the risks, an investor will be able to effectively utilize the resources available to avoid the risks. For instance, when there is likelihood of limited supply of materials, the management of an organization can be able to make use of the available resources effectively so as to avoid stock outs (Anne & Sylvie2012). In addition, risk management helps to reduce fraud within the investment. Without managing the risks, the investment can be bankrupt due to embezzlement of financial resources and other resources (Anne & Sylvie2012). Through risk management, there will be strategies for obtaining any property from the investment thus reduces fraud and improve the utilization of the available resources. Risk management further enables an investor to understand the kind of reinvestment to make. Once there is an opportunity to make another investment, the investor has to consider the risks associated with the first investment before making another investment. This will help to select the most appropriate form of investment. It leads to improved performance of an organization. When risks are better managed by an investor, there are high chances of excelling in the market (Anne & Sylvie2012). This is because the production or manufacturing process cannot be affected thus various operations within an organization are coordinated well. This leads to better performance of an investment. Further, risk management can be a source of competitive advantage to an organization. An investment which is better managed in terms of risks can attract many customers (Quan Li 2006). This is because the customers will have trust with the management of the company than those of the competitors thus leading to attraction of many customers. Therefore risks can help to improve the market share of the company and by attracting and maintaining many customers. Risk management also leads to better delivery of services. For instance, in a manufacturing industry, the risks of supply of materials can be managed to improve service and product delivery to customers (Quan Li 2006). When there is poor risk management, the investment might be interrupted in terms of giving services and products because of stoppages in production. With risk management, there will be no stock outs since the process of acquiring the inputs is smoothly managed till the products reach the end user who is the client thus better services delivery. Risk management can also lead to lower cost of capital. There are various ways in which risk can reduce the cost of capital. After assessing the various risks in the market, an investor will be able to make a wise decision on the best source of capital (Quan Li 2006). This is after considering the fluctuation rates thus select the best source which cannot be affected by changes in the interest rates. Therefore, risk management helps to select the best source of capital and forgo other sources which have more risks. Conclusion A risk can be defined as the possibility of occurring of a loss to an investment. Risks affect the performance of an investment if they are properly evaluated. Risks can be diversified or non-diversified. Diversified risks are the risks associated with the changes in the market environment while non diversified risks are the risks associated with a particular sector. There are various types of risks and they include credit risks, interest rate risks, liquidity risk, exchange rate risk, political and market risk. In order to manage the risks, the following strategies are applied; avoiding risks, diversification of risks, insuring investments, take protected investments and following up the market trend. Risk management is important to an investment because it helps to avoid unwelcome surprises, helps in effective utilization of resources, leads to improved performance of an organization, reduces the cost of capital and better service delivery. Works Cited Andy, Phippen. & Simon, Ashby. Digital Behaviors and People Risk: Challenges for Risk Management, Jossey-Bass, San Francisco, 2013. Anne, Fortin. & Sylvie Berthelot. A Risk Disclosures and Nonprofessional Investors' Perceptions and Investment Decisions, Minneapolis: Lominger, 2012. Arvind, Jain. Governance and Political Risk. London: Emerald publishing group, 2006. Jonathan, Batten. & Niklas, Wagner. Derivatives Securities Pricing and Modelling, Blackwell: Oxford, 2012 Quan Li, Political Violence and Foreign Direct Investment. London: Emerald publishing group, 2006. Read More