Aug 28, 2022
All investments have a certain degree of risk owing to market conditions and the nature of specific businesses. In times of high uncertainty, investment risk tends to increase and decline during times of low uncertainty. Currently, the global economy is hailed by increased uncertainty emanating from elevated inflationary pressures, persistent supply chain bottlenecks, resurgence of COVID-19 infections and the prevailing geopolitical pressures. Closer home, Kenya has not been exempted with the uncertainty evidenced by increased investor sell-offs in the Nairobi Securities Exchange, increasing yields and the undersubscription of government securities. The uncertainty has also been reflected in the business environment characterized by slow activity with the average purchasing managers index (PMI) coming in at 48.8, in the first seven months of 2022. In light of the developments, we shift our focus to investment risks analysis in Kenya where we will discuss the types of investments risk and look at how investors can manage such risks so as to maximize returns while minimizing loses.
We shall cover the topic as follows;
- Types of Investment Risks,
- Investment Risks Management Strategies,
- Advantages and Disadvantages of Investment Risk Management, and,
Section I: Introduction
An investment refers to the acquisition of an asset or an instrument with the objective of generating income or increasing value over time. An investment risk on the other hand refers to the degree of uncertainty with regards to realizing the returns as projected by an investor. Key to note, the level of investment risks varies depending on the type of investments made and the higher the risk, the higher the return. The fixed income asset class is considered as a low risk investment as they act as a safe haven for investors during periods of increased economic uncertainties. The equities asset class on the other hand is regarded as a high-risk investment due to their sensitivity to market fluctuations. As such, investors are required to consider various factors when investing to ensure that they maximize their returns while avoiding unnecessary losses. Some of the factors include;
- Expected Returns – When investing, it is essential to consider the expected return and whether it aligns with an investor’s expectations. The returns can be in the form of interest, dividend or capital gain or loss. It will also be essential to understand one’s risk profile to ensure that an investor carries the risk they can tolerate,
- Liquidity – Refers to how quickly an investment can be converted or exchanged to money through the sale of an instrument or redemption of a matured security. The choice of investment is guided by investors’ financial needs as it determines how soon they require their money back,
- Volatility – An investor should understand the pace of fluctuations that an investment endures. The level of volatility will determine the nature of risks involved since the higher the rate of fluctuations, the higher the risk of profit or losses,
- Time Horizon – Prior to investing, one should understand the duration to hold an investment before redemption or selling. However, time horizons depend on the nature of instruments such as equity instruments, debt instruments and also age profile, and,
- Risk Return Analysis – When making investment decisions, it is essential to understand what type of risks an investment attracts. Investments in traditional instruments such as gold, fixed deposits and bonds have lower risks but with lower returns compared to listed securities.
Section II: Types of Investment Risks
Investment risks are broadly categorized into two; Systematic and Unsystematic risks as follows;
- Systematic risks - These are market related risk which an investor cannot mitigate through diversification of the portfolio. Systematic risks are mainly caused by factors that are external to an individual or organization and are inter-related to macro-economic indicators such as inflation, Gross Domestic Product (GDP), exchange rate variability and interest rates. The various types of systematic risks include:
- Inflation/Purchasing Power Risk – Inflation refers to persistent and sustained increase in general price levels which consequently reduces the purchasing power of money. Inflation risk is, thus, the potential of reduction in the actual worth of an investment and its return owing to inflation. It mostly affects fixed income securities as their income is fixed on nominal terms,
- Reinvestment Risk – Refers to the potential of loss attributable to reinvesting investment proceeds at a lower rate than the rate of the initial investments. It mostly impacts long term investments, equities, and the zero-coupon bonds,
- Interest Rate Risk – The risk arises as a result of changing interest rates in the market. Any change in the interest rate as a result of market forces alters the return on investments, mostly fixed income securities as bond prices for instance, are inversely related to the prevailing market interest rates, and,
- Exchange Rate Risk – This is the risk arising from the fluctuation in the value of foreign currency with respect to the local currency. Exchange rate risk affects only the securities of companies or individuals with foreign exchange transactions or exposures, which altars the actual worth of such an investment.
- Unsystematic risks – Refers to risks unique to a particular company, individual or industry and can be reduced to a certain extent by diversification. Unsystematic risks mostly arise from the management, location, or the financial obligations of the investor. The various subdivisions of unsystematic risks include;
- Liquidity Risk – this is the possibility of not being able to convert an investment into ready cash when need arises or the difficulty of finding a buyer in the market when one needs to liquidate their investments,
- Financial Risks – Refers to the uncertainty in the expected returns as a result of changes in the financial structure of a company. Only risk-free assets give returns equal to the expected returns. An example of this risk is when a firm has no capacity to meets its business obligations hence unable to pay dividends or even interest,
- Political Risk– This refers to risks arising from changes in the legislations, trade barriers, or any other political decision that could have negative impact on the projected rate of return from an investment,
- Business Risk- This is the uncertainty in the returns of an investment due to volatility in a firm’s operating income,
- Legal Risk – Refers to the potential of a loss emanating from insufficient knowledge or misunderstanding of how the law applies to your investment, and,
- Investment Manager Risk – It is the risk linked with ineffectiveness and inefficiency of an investment manager to manage risks prudently.
Section III: Investment Risk Management Strategies
As an investor, it is essential to take steps towards minimizing investment risks to realize the expected return. Investors should be cautious by applying prudent investment risk management strategies to ascertain that losses do not exceed an investor’s acceptable boundaries. The right strategy should enable an investor to understand the risk tolerance and create a portfolio with investments in line with an investor’s goal. Below are some of the risk management strategies that investors can apply in their investment portfolios;
- Understanding one’s risk tolerance – Risk tolerance measures the degree of loss an investor is willing to withstand. It is determined by a number of factors such as age of the investor and the financial obligations. Once investors understand their risk tolerance, they can decide on which asset classes to invest in, according to the best risk-return value for managing the investment risk,
- Maintain sufficient liquidity in the portfolio – Sufficient liquid assets in the portfolio are important as this ensures the existing investments deliver optimal-long term returns and benefit from periodic market corrections. It will also protect against liquidity risk in the investment market. Additionally, one can maintain sufficient liquidity in the portfolio by setting aside an emergency fund which falls within 6-8 months of expenses,
- Hedging – Refers to minimizing risks by buying a security to offset a potential loss on another investment. Hedging strategy does not guarantee that investments will not lose value at all, however, it mitigates losses by gains recorded in another investment. The most common form of hedging is a derivative or a contract which is valued through an underlying asset,
- Diversification – The strategy involves investing in more than one asset class to reduce the investment risks to provide optimal returns. A suitable investment mix can have asset classes such as Equity, Debt, Real Estate, Mutual Funds, Gold, among others. It is also advisable to have a combination of asset classes that are inversely correlated with each other such as gold and equity to bring out portfolio balance. Investors can also reduce the overall risk by diversifying investments under the same asset class,
- Invest for a long horizon – It is prudent to stay longer in the market to take advantage of compounding. A longer investment horizon ensures that the portfolio is not affected by small market corrections and will also reduce the overall investment risk. However, this strategy is only suitable for investments such as in stocks and bonds. Key to note, investors should select an investment horizon that is in line with their financial obligations,
- Undertake due diligence – As an investor, it is essential to carry out comprehensive research before making an investment decision. When investing for long term purposes, it is vital to understand the performance of the management and look into key ratios. Detailed analysis helps in forecasting the performance of an investment in the future,
- Continuous monitoring – An investor should always monitor the performance of their portfolio regularly and undertake periodic reviews. Typically, portfolio reviews should be done once in six months to look into asset classes that are prone to short term volatility such as equities. Long-term investors have the advantage of overlooking short-term shocks in investments and only alter an investment if it shows poor performance over an extended duration, and,
- Establish a maximum loss plan – This is a method that investors apply to cautiously manage asset allocation in their portfolio. It protects investors from making bad decisions based on emotions about market movements. The strategy calculates a personal maximum loss limit and uses the percentage to establish appropriate asset allocation for an individual investor. The calculation is usually based on historic market numbers and personal feelings about market losses and investors will have the leeway to adjust the prices depending on what is happening in the market.
Section IV: Advantages and Disadvantages of Investment Risk Management
Investment risk management is important as it protects investors against extreme and unnecessary losses. Some of the benefits of risk management include;
- Helps in spreading risks – Risk management through diversification is beneficial as it helps spread out risks and provides better opportunities of making money and protect investors from panic selling as it will be impossible to sell all your assets in case the market is crushing,
- Longer investment horizon offers compounding returns – Investing in a long-term investment horizon is advantageous since the longer your investment duration the more time you have to correct the ups and downs in the market by recovering the losses. Having a clear investment horizon is essential in managing risk by deciding on which assets to invest in depending on the risk tolerance level and financial needs,
- Making conscious decisions – Undertaking proper research enables an investor to understand the nature of investments from all angles to avoid being blinded by unforeseen events. As a result, an investor will make conscious decisions from an informed point and avoid confirmation bias, and,
- Avoiding Catastrophic losses – Investment risk management prepares investors for the different types of shocks in the market as they are able to see and adjust the small shocks that continuously affects the market. Additionally, risk analysis prepares investors to foresee potential catastrophic events that causes catastrophic losses and how to respond in such situations.
Despite the benefits that come along with investment risk management, there exists shortcomings arising from the same. This include;
- Time Consuming Process - The process of managing investment risk is usually a complex process. It involves technical analysis and data collection and requires a lot of accuracy. As such, the process will require a lot of time,
- Expensive - The process of risk management involves technical analysis and data collection which is usually expensive hence an investor needs to set aside enough finances for the process,
- Certain risks depend on external factors - Not all risks are manageable as some are usually dependent upon external factors which an investor cannot control,
- Accuracy of determining investment risks relies on various variables - The process of determining accurately an investment risk will rely on a variety of factors such as the strength of the model being used, the viability of the assumptions, and the quality of data used in the analysis
- Tying up money in long term investment – Risk management by investing in longer time horizon has a downside of tying an investor’s money for a long duration thus missing on other viable short-term investments opportunities. Further, investing in long-term duration is not a guarantee that investments will perform better by correcting market volatilities. Such strategy requires patience and continuous monitoring, and,
- Being too cautious – In some instances, investors may be paralyzed by analysis as one may overthink an investment hence fail to make the right decision. Failure to strike a balance between being too risky and too risk averse may make investors to talk themselves out of profitable investments.
Investing in an uncertain business environment is not a welcome idea for most investors as most of them tend to hold their funds and wait for periods with low uncertainty. This is despite the fact that there may be profitable opportunities through the various investment channels available, with the main challenge being fear of making losses. In our view, investors should implement investment risk management strategies, consult with financial advisors if necessary, and conduct due diligence to capitalize on the various seasons, whether they are uncertain economic times or periods of a stable economic environment. This will ensure that investors do not waste opportunities or incur unnecessary losses given that the current economy is constantly affected by unprecedented phenomena.
Disclaimer: The views expressed in this publication are those of the writers where particulars are not warranted. This publication, which is in compliance with Section 2 of the Capital Markets Authority Act Cap 485A, is meant for general information only and is not a warranty, representation, advice or solicitation of any nature. Readers are advised in all circumstances to seek the advice of a registered investment advisor.