5 Types of Risks You Should Know

Whatever action you take with your money, consciously or unconsciously, involves taking a risk. Even failing to take action is a risk in itself. 

To achieve your financial goals, increase your income, and build and protect your wealth, you will have to take a path of uncertainty.

Risk is the possibility that your investment's outcome will differ from the expected returns and the chance that you might lose some or all of your initial investment. If you invest money, there is a chance that it might generate more money or disappear into thin air. 

While risks cannot be eliminated entirely, understanding how they manifest themselves can help lower their effects on your finances. 

Take time horizon risk, for instance. This is the risk that your investment time frame might be shortened by an unplanned event like a major health complication that forces you to liquidate your assets. 

You can invest in comprehensive health insurance to prevent yourself from facing this risk when faced with such an event.

Read Also: If Hospital Bills Can Bankrupt Your Family, What Can You Do Now? 

But it's not all that simple. Time horizon risk is not the only uncertainty you face when investing, nor is a significant health crisis the only event that could force you to liquidate. 

They're other types of risks that you will be exposed to. Some you can control and mitigate. Others will be beyond your control.

This article will explore five common types of risks, how you can assess them, and what you can do to reduce their impacts. 

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Market Risks

This is the risk of your investments losing value because of events affecting the entire market. The uncertainties are typically brought about by circumstances out of your control. The three main types of market risks include:

Interest Rate Risk: This risk involves losing money because of a change in interest rates. It mostly affects investments that include debts such as bonds and mortgages. The CBK decides interest rates through the Monetary Policy Committee (MPC), which announces changes at least every two months. 

Since interest rates go up and down, their risks cannot be eliminated. You can, however, moderate trying to create more predictability. This will involve investing in debt instruments that offer fixed interest rates. 

Equity Risks: This is the risk of your investments depreciating because of market development. This risk is specific to assets affected by market development, such as shares and stocks. They're brought about by events that can affect an entire market, such as political turmoil that spreads shocks across a country's stock exchange.

Exchange-rate Risks: This risk is in relation to investments that are heavy on foreign currency. When the foreign currency weakens against your country's or preferred currency, your money/investment that is in the local currency will be worth less. These risks can also affect you when you invest in companies that use foreign currency to conduct their business, such as in the import-export business.

Since market risks are out of your control, they cannot be realistically entirely averted. However, you can mitigate them by diversifying your portfolio through different industries and going for long-term investments that allow you to withstand short-term market volatility. 

When investing for short-term goals, you can consider avoiding volatile investments that expose you to market risks.

Read Also: 7 Short-Term Financial Goals to Set For Yourself

Liquidity Risk

Liquidity risk occurs when you cannot sell off an asset or get out of investment without risking loss. You might have to sell at a low price or pay fines to get out of a position. 

In some cases, you might ultimately be unable to liquidate. This risk can affect illiquid investments such as fixed deposits, real estate, private company shares, bonds, and other debt instruments.

Liquidity risks occur when you need cash but can't find a buyer to pay a fair or market price for your asset. You can mitigate against this type of risk by having a solid emergency fund and evenly spreading your investments through liquid and illiquid instruments. 

Understanding your investment time frame can also help you hedge against liquidity risks. For example, when investing for short-term goals, you can go for vehicles that can easily be liquidated without you suffering any loss.
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Credit Risks

Credit risk (also known as default risk) can affect you when borrowing money, lending money, or investing in debt instruments like bonds. It can manifest in three ways.

1. You default on your loans - When this happens, your creditor can charge you extra fees or repossess assets used as collateral.
2. Your borrower defaults - This happens when you lend your money and don't receive your principal and/or interest and have to write it off.
3. Bonds - This risk happens when you invest in bonds, but the issuer (government or company) runs into financial difficulty that prevents them from paying interests or principal at maturity.

Credit risk can also affect you if you have a bad credit history. Lenders will often look at your creditworthiness before deciding on the interest rates to offer you. Good credit history can give you an upper hand in negotiations, and you can borrow money at lower rates.

You can lower your exposure to credit risk by borrowing money you can afford to pay back, lending money you can afford to lose, and investing in debt instruments with the lowest risks like government-backed treasury bonds.

Read Also: Is Investing in Government Bonds a Good Idea? (Pros & Cons)

Inflation Risk

Inflation risk is the possibility of losing buying power when the value of your investments fails to keep pace with inflation. Inflation risk is one of the main reasons to invest and presents the most danger if you hold your money in cash or cash equivalents. 

Inflation is caused by the rising cost of living, weakening the Kenya Shilling against hard currencies, and economic shocks due to internal and external forces. 

Inflation has caused the purchasing power of the Kenyan Shilling to fall. A recent report published in the Business Daily shows that the Shilling has lost 45% of its buying power since 2013. 

Even though wages have increased over the same period, it hasn’t kept up with inflation which has hovered around 6.2% in the past ten years.

To mitigate the effects of inflation risk, you can diversify your investment in vehicles that pay dividends and guarantee capital appreciation. 

Read Also: Rising Inflation: Where Should You Keep, Invest Your Money?

Longevity Risk

Longevity risk is the risk of outliving your savings. Advancement in healthcare and improved living standards has led to an increase in life expectancy, which is only set to get higher. Without proper retirement planning, you face the possibility of running out of money. 

Since you don’t know how long you will live, you have to prepare to spend more years in retirement. That means saving and investing in income-generating vehicles that will help you be self-dependent and start early. Other ways to lower your exposure to this risk include planning to retire later and adequately insuring yourself by getting health, long-term care, and life insurance.

Read Also: Money and Me: Insurance, a True Life Saver 

WRAPPING UP 

Building wealth and achieving your financial goals will involve taking some degree of risk, primarily when investing. And even the safest investments pose a level of risk. Any investment that promises returns and no risk should be taken with a pinch of salt. 

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While uncertainties cannot be avoided, you can soften their effects. You achieve this by assessing the type of risks you face before taking a step and drawing up a plan to manage the risks. 

This means you will have to dedicate time to learn about each investment and keep up with its development once you enter a position. 

Learning about an investment product won't just be enough. You have to educate yourself about the entire industry, its previous history, current standing, and most importantly, future trends and projections.

Another great way to manage risks is by diversifying your assets and investment, depending on your risk tolerance and financial goals. 

You can spread your risks through different assets, industries, and even countries. Finally, you should consider talking to a financial advisor to help you understand how you can mitigate the risks you face. 

Read Also: 7 Ideas to Diversify Your Sources of Income