While you and everyone else would welcome the concept of investing without exposing yourself to any risks, the truth is it doesn’t exist.
The best step to take is to prepare for these risks and have solid strategies to mitigate or avoid them entirely. This is even more crucial when investing in instruments that carry systematic risks.
Systematic risks refer to the risks that are inherent in the whole market or part of the market and, in most cases, are unpredictable and unavoidable. Systematic risks, also known as market, volatility, and undiversifiable risks, are typically caused by events outside your control. Those events include inflation, fluctuations in interest rates, wars, political unrest, etc.
When investing, it is essential that you factor in these risks when allocating your assets or diversifying your investments. Even though you won't be immune to these risks, you should take steps to minimise their effects on your finances. And the first stride should involve learning what they are.
This article will explore five systematic risks you face when investing, what they are, and what you can do to ensure they don’t leave a massive dent in your finances.
Currency or exchange rate risks are a type of risk factor you face when you hold foreign currency or investments. There is a degree of uncertainty when dealing with foreign currencies as they tend to fluctuate in value in relation to the Kenyan Shilling. Events that lead to an unwelcoming economic environment, such as unrest, can cause the value of the country’s currency to fall.
When that happens, and you exchange the foreign currency back to Kenya Shillings or another secure currency, you will receive less money than you had initially invested.
You are also exposed to currency risks when you invest in companies that are heavily reliant on foreign currency to conduct their business operations, mainly imports and exports. When this happens, you will likely receive fewer returns than expected if the fluctuations are against the company.
Currency risks can’t be predicted; the best thing to do is to be aware of them and hold stable currencies. When investing in businesses that depend on foreign currency, ensure they operate using safe world currencies that are accepted everywhere and can be easily exchanged.
This risk represents the possibility of making losses on your investments due to sudden changes in interest rates. The Central Bank regulates interest rates in Kenya through the Monetary Policy Committee (MPC), which announces new rates every two months. Depending on how the rates fluctuate, you can save or risk losing money.
Interest rates can affect the return you earn on your savings, but mostly they'll have higher effects on your debt instruments like mortgages and bonds investments. Your bonds will yield fewer returns when interest rates go down, and if you have a variable mortgage loan, you'll pay more monthly installments when interest rates are up.
Interest rate risks can’t be eliminated due to their unpredictable nature. However, to lower your exposure, you can invest in debt instruments that offer fixed interest rates, but that also exposes you to opportunity risks. For instance, if rates fall and you are servicing a loan with high interest, you'll be paying more than current market rates, effectively losing the opportunity to save money.
Another way to avoid interest rate risks is to invest in short-term debt instruments like treasury bills instead of bonds. Since you buy these instruments at a discount and receive the face value on maturity, you won't be affected by fluctuations in interest rates.
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This is the risk of your investment losing value due to market development. They affect assets you bought specifically for their appreciation value rather than income generation. These assets include stocks, company shares, or real estate. When demand is low or a country is facing unrest like political turmoils, the value of your investments might significantly drop.
If you get out of an investment position at such time, you might be forced to sell at a loss or below market value.
Avoiding this risk factor is tricky since you can’t tell when the market risks will present themselves; however, you can consider the market depth when entering a trading position. This will help you create a timeline on when to exit and help you keep up with all events that could affect your investments. If the causes of the risks are temporary, you can decide to ride out the volatility and sell when markets have recovered.
Portfolio rebalancing can also help you allocate your assets by favoring investments that perform better in the current economic climate and eliminating those not doing so well.
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This is the risk of suffering significant losses caused by various market risks for holding a large portion of your wealth in a single investment, asset class, or market segment.
Gathering all your assets in one or similar investments exposes all your wealth to the same market risks. For instance, if much of your investments are allocated in illiquid investments such as bonds and fixed deposits with variable interest rates and the CBK drops interest rates, you risk making less money than you might have planned.
You can avoid concentration risks by:
Diversifying: Spread your assets across different asset classes with varying risk factors to ensure one type of market risk doesn't affect all your investments.
Rebalancing: Some concentration risks can occur on their own when one of your investments significantly outperforms other investments to the point that they represent much of your wealth. To avoid this risk, you have to rebalance and diversify across various assets or return them to their original form.
Liquidity risk refers to losing some of your initial investments when exchanging your assets for cash or being unable to get out of an investment position.
How fast you can sell your assets for cash will generally depend on the market demands. Some assets tend to be more liquid than others; that is, they can be exchanged for cash at any time for their current market value. For example, stocks can be sold anytime, granted the markets are open.
On the flip side, some assets have low demand or are generally hard to liquidate, especially in emergencies when you need cash. You will be forced to consider reselling or selling below market value in such instances. Assets like real estate can take time to resell. They involve cumbersome processes that can take months and if encumbrances arise– years.
Some other investments like fixed deposits, annuities like pension plans and life insurance, and bonds are also illiquid. Getting out of these investments might involve forfeiting any interests you have accumulated, and you might also be penalized, which results in you making two losses concurrently.
Always enter an investment position with a well-defined time horizon to avoid liquidity risks. Know exactly when you can access your funds, and beware of the penalties you face for early withdrawals. You can prevent this by reading the fine print before agreeing to the terms.
You should also keep your rainy day funds in easily accessible, less risky investments, and not prone to market volatility. This will ensure you don't lose money when you need to liquidate to attend to your emergencies.
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Market risks are unavoidable, and you are exposed to them if you invest and take action to improve your overall finances. Their unpredictable nature makes them hard to avoid.
Nonetheless, you should be prepared for them when you face them. Diversifying when allocating your assets, understanding your risk tolerance, investment goals, and investing time frame will help you minimise their adverse effects on you.
You should also note that staying dormant and not investing doesn’t make you immune to market risks. You still face inflation risk– a type of market risk that affects your money's purchasing power. You should there take steps to preserve yourself from this risk and ensure your savings can be of substance in the future when you need them.