In the previous chapter, we introduced the two types of risks: systematic and unsystematic. We then explained in detail the key systematic risks an investor needs to be aware of and how to reduce those risks. In this chapter, we will continue from where we left off previously and discuss some of the key unsystematic risks that an investor needs to be aware of, at all times, as well as how to mitigate them.
Business Risk
Business risk is a risk that affects a specific company due to uncertainties regarding a company’s financial statements. For instance, there may be a question mark on the revenues of a firm because of uncertainties surrounding demand for its products and services, or there may be expectations that revenues may not rise sufficiently to offset rising operating costs, which in turn could lower the profit potential of a company. Business risk can arise not only due to internal factors but also due to external factors such as increasing competition among existing companies, entry of new companies offering similar products and services, emergence of substitute products and services due to technological advancements, unexpected hike in raw material prices by a key supplier, changes in tastes and preferences of consumers etc. These factors can weigh on the bottom line of a company and thereby put downward pressure on the company’s share price as well. Moreover, sometimes, business risk can impact several companies within one sector/industry due to external forces. For instance, if the government raises tax on liquor, it can have an impact on all liquor companies rather than just one.
The best way to reduce exposure to business risk is by diversifying holdings of stocks across market sectors and industries. This way, by holding stocks across market sectors, the portfolio is unlikely to be impacted much in case one or a few stocks decline in value due to the emergence of business risks affecting only those stocks/sector. At the same time, it must be kept in mind that over diversifying one’s portfolio can impact the overall investments adversely and reduce the gains.
Credit Risk
Credit risk is a risk where there is a possibility that a counterparty might fail in fulfilling its financial commitment (i.e., a risk of default). This is a risk that particularly concerns the holders of fixed income instruments, such as bonds and debentures. While government securities tend to be risk-free, those that are issued by companies and financial institutions have an element of credit risk attached to them. This is because the issuer might fail to make a timely payment of the periodic interest and/or the principal amount in full. While there might exist a relatively low risk at the time of the issue, this risk might increase over the life of the instrument due to changes in macro-economic, micro-economic, and/or issuer-specific factors. Credit risk also exists in derivative contracts that are traded outside the exchanges i.e., private derivative contracts.
Credit risk can be reduced to a great extent by diversifying your fixed income portfolio across a range of securities having varying levels of maturity. Also, as securities such as bonds and debentures are assigned a credit rating by rating agencies (such as CRISIL, ICRA, and CARE in India, and Moody’s, Fitch, and S&P in the US), one needs to look at the rating of a security before investing. Also, note that credit ratings can change over time, depending on various external and internal factors that affect the repayment ability of the borrower. Hence, even after investing, one needs to periodically monitor the rating of instruments in the portfolio. As a rule of thumb, the higher the credit rating, the safer the security tends to be, and vice versa. That said, there will be a trade-off here. A higher credit rating would usually translate to a lower interest rate, and vice versa. Hence, the investor needs to look at his/her risk profile and reward expectations and accordingly decide whether to include only higher-rated securities or a combination of higher and lower-rated securities.
Operational Risk
Operational Risk arises when internal events affect the smooth functioning of an organization. This risk could arise due to a range of issues such as fraud committed by key personnel, errors made by employees, technological inefficiencies, labor problems, weak company management or change in management personnel etc. These events can impair the operations or the normal functioning of an organization, which in turn could significantly hurt the profitability of a firm and, in some cases even lead to losses. The Satyam scandal uncovered in 2008-09 can be described as an operational risk for the company, while affecting the credibility of other firms in the sector.
Just like business risk, the best way to reduce exposure to operational risk is by diversifying stock holdings across market sectors and industries.
Liquidity Risk
Liquidity risk can be spoken from two standpoints: one relating to business and the other relating to trading. Liquidity risk in a business arises when a company struggles to repay or refinance its existing debt or in meeting the current dues of its creditors. This could be due to reasons such as a short-term cash crunch and the inability of certain assets to realize cash quickly or poor business conditions leading to insufficient cash flows. So, in a way, this is similar to business risk that we discussed earlier, given that it affects only one company. Meanwhile, liquidity risk in trading arises when a market participant finds difficulty in entering or exiting trades at the prevailing market price. The reason could be insufficient buyers or sellers on the other side of the transaction. In such a case, a trader might have to transact at an unattractive price, which could affect the profitability of a trade and in some cases even lead to losses.
Liquidity risk in business can be diversified by investing in stocks across market sectors and industries. Further, before as well as after investing in stocks, especially those from the smallcap and microcap space, one must periodically look at the financial statements to gauge short-term liquidity situation of the company. Current ratio and quick ratio are two of the most widely used ratios that help in measuring the short-term liquidity situation of a company. Investors need to pay attention to the cash flow statement, especially cash flow from operations. Meanwhile, liquidity risk in trading can be eliminated by buying/selling only those securities where there is ample liquidity. Illiquid securities or securities where liquidity is too low must be avoided. How does one look at liquidity in stocks? Past and current volumes and prevailing bid-ask spread are good measures to measure liquidity. The higher the volumes and the narrower the prevailing bid-ask spread, the more liquid the security tends to be, and vice versa.
Regulatory Risk
Regulatory risk arises when changes in laws and regulations impact the financials of a company. Every company within a market sector is bounded by laws and regulations set forth by the regulatory bodies governing that sector. Companies must ensure that these are strictly complied with, failing which they could face legal penalties. Furthermore, the laws and regulations that govern a company, such as tax policies, domestic and international trade policies, labour policies, environmental policies can change over time depending on the evolving economic, political, and environmental landscape. Such changes could increase operating costs of the firm and also affect the way in which a firm conducts its business. Similarly, regulatory or legal risks can also arise when companies fail to fulfil contracts they have entered into with counterparties, or when there is a copyright or patent infringement, etc.
Regulatory risks usually tend to be unsystematic, as they affect only a particular company or a sector of which that company is a part of. For instance, an increase in import duty of rubber is likely to impact tyre manufacturing companies, but not, say, IT companies. On the other hand, changes in US H-1B visa policies can impact IT companies, but not, say, insurance companies. Hence, regulatory risk can be mitigated by diversifying stock holdings across market sectors and industries.
Reputation Risk
Reputation risk arises when an organization engages in activities that could put its image or goodwill at stake. Reputation risk could arise due to several factors. Examples include conducting business in an unethical manner, fraud committed by the company or any of its key personnel, failure to make timely payment of existing debts, making products that harm the environment, poor labor practices, untimely declaration of financials and other price sensitive information etc. Sometimes, reputation risk could also arise for issues over which the company has no direct control. This is especially true in today’s digital world where adverse information or rumours can spread at a lightening pace and across geographical boundaries. Any negative news about a company, whether true or false, spread on social media platforms can adversely impact its image in public eyes.
Reputation is one of the biggest assets of a company and has a direct impact on its revenues and profitability. Hence, any actions or events that dent a company’s reputation can have severe repercussions on the company’s financials and share price. In extreme cases, a loss of reputation can lead to a total loss of public and investor confidence, which in turn could cause a company to go bankrupt. The 2015 Volkswagen emission-cheating scandal is a good example that seriously dented the image of the company globally, cost them billions of dollar in fines, and caused the share to nearly halve within a few weeks after the scam came into light.
Reputation risk is specific to a company and hence its impact can be reduced to a significant extent by including in your portfolio several stocks (preferably across sectors and industries) rather than just a few. This way, if loss of reputation causes one stock in your portfolio to under perform or fall in value, your portfolio still will not be affected much.
Conclusion
Well, the risks mentioned in this chapter and in the previous chapter are the ones that investors are most exposed to, most of the times. Hence, it is important to be aware of them and take appropriate steps to eliminate/mitigate those risks. While some risks can be diversified to a significant extent, others can be reduced to certain extent only, via diversification. Let us quickly summarize the two types of investment risks that we have studied so far:
In the next chapter, we will talk about the key risks that traders are exposed to and how to reduce those risks.
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