This article will discuss 5 important risks for every investor. However, firstly let us understand the definition of risk.
Every investment takes a risk. In the financial world, risk refers to the probability that an investments’ actual gain will be different from its expected return. It also means a chance of one losing some or all money they have invested. There is a popular concept between “risk and return,” that says “high risk, high return.” It includes the idea that risk is the volatility of investment returns. Furthermore, it is measurable and manageable. To assess risk, we can use a standard deviation as a metric that could measure the volatility of asset prices compared to their historical averages in a specific time frame.
In addition, the Shariah principle fully acknowledges the existence of risk. There is a principle of al-ghunm bi al-ghurm in Islam: gaining a profit comes with bearing the risk involved. In other words, an investor who will enjoy any return shall also be the one who stands ready to cover any costs or losses that may result from their invested business.
There are two broad types of financial risk: systematic and unsystematic. Systemic risk is a risk within the overall system which applies to the entire market, affecting all investments. The major example of systematic risk is the financial crisis of 2007-2008. Meanwhile, unsystematic risk refers to diversifiable risks that happen in a specific company or industry. This type of risk shall be diversified away through other investments.
Furthermore, We summarized 5 types of risks that every investor should know:
1. Credit Risk
Credit risk is a possibility that the businesses or companies you invested in cannot pay you any return or even pay back your principal on their debt obligations. In financial institutions, credit risk specifically refers to the risk of loss happening due to a borrower’s failure to make required payments.
2. Business Risk
The term business risk refers to the exposure to the factors that causes inadequate profits or lead it to failure. When entering a market, every business will be exposed to a business risk that negatively affects it. The business risk includes various factors such as competition, consumer preferences, government regulations, and economic conditions.
3. Market Risk
Market risks can happen as a result of macro or micro sources. It is the possibility of your investment value will fall due to market risk factors namely:
- Commodity risk (risk due to fluctuations in commodity prices)
- Equity risk (risk of changing stock market prices)
- Interest rate risk (happens due to fluctuative interest rates)
- Currency risk (happens due to fluctuations in currency values)
4. Inflation Risk
Inflation risk or purchasing power risk occurs when the actual gain of your investment won’t be worth as much in the future due to inflation eroding the purchasing power of your money. For example, if you have a deposit with 10% of return today, then let’s say inflation has been 8% in that year, your actual return drops to 2% regarding its purchasing power. Investors should consider inflation risk when dealing with long-term investments, especially its cash flows and calculating expected returns.
5. Foreign Exchange Risk
Foreign exchange (forex) risk happens to the financial instruments that are denoted in foreign currencies. For instance, if a US firm has invested in Japan, there is a risk the US firm will lose money because the Japanese yen has depreciated against the US dollar. Thus, once the company pulls out its investment on maturity, it will get fewer US dollars on exchanges.
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