Page 48 - DMGT515_PERSONAL_FINANCIAL_PLANNING

Unit 3: Managing Investment Risks

Notes

Notes The management of actuarial risk is called risk management.
3.2 Types of Investment Risk

There are many different types of investment risk. The two general types of risk are:
Losing money, which you can identify as investment risk
Losing buying power, which is inflation risk
It probably comes as no surprise that there are several different ways you might lose money on
an investment. To manage these risks, you need to know what they are.
Most investment risk is described as either systematic or non-systematic. While those terms
seem intimidating, what they refer to is actually straightforward.
Systematic risk: The systematic risk affects the entire market. Often we hear that stock market is
bear hug or in bull grip. This indicates that the entire market is moving in particular direction
either downward or upward. The economic conditions, political situations and the sociological
changes affect the security market. There are factors which are beyond the control of corporate
and investor. They cannot be entirely avoided by the investor. It drives home the point that the
systematic risk is unavoidable. The systematic risk is further sub divided into:
Market risk
Interest rate risk
Purchasing power risk

Market risk: It is defined as that portion of total variability of return caused by the
alternating forces of bull and bear market. When the security index moves upward haltingly
for a significant period of time it is known as bull market. In bull market the index moves
from a low level to the peak. Bear market is just a reverse to the bull market.
The forces that affect the stock market are tangible and intangible events. The tangible
events are real events such as earthquake, war, political uncertainty and fall in the value of
currency.
Intangible events are related to market psychology. The market psychology is affected by
the real events. But reactions to the tangible events become over reactions and they push
the market in a particular direction.
Any untoward political or economic event would lead to a fall in the price of the security
which would be further accentuated by the over reactions and the herd like behavior of
the investors. If some institutions start disposing stocks the fear grips in and spreads to
other investors. This results in a rush to sell the stocks. This type of over reaction affects
the market adversely and the prices of the scrip fall below their intrinsic values. This is
beyond the control of the corporate.

Purchasing power risk: Variations in the returns are caused also by the loss of purchasing
power of currency. Inflation is reason behind the loss of purchasing power. The level of
inflation proceeds faster than the increase in capital value. Purchasing power risk is the
probable loss in purchasing power of the returns to be received. The rise in rice penalizes
the returns to the investor, and every potential rise in price is a risk to the investor.

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