Investment Risks: How to Successfully Identify Them?
Investments are tools which help firms achieve their goals. Where a company decides to invest, therefore, is invariably tied to its goals and corporate strategy. Investment risk is the probability of losses from any investment the company makes, most often due to a decline in the value of the item invested in. This can be items such as stocks, bonds, real estate, mutual funds, commodity futures etc. There have even been cases where companies have bought artwork or cryptocurrency, both of which they feel will appreciate with time. But every investment is inevitably exposed to some degree of risk; rule of thumb is, the higher the risk, the higher the returns.
In addition, each investment has its own features and risk factors. Firms should also consider how these risks may affect the whole enterprise in general. Market risk, for instance, is quite extensive as it covers equity, interest rate and currency risk. Then there is liquidity risk, which is the risk which comes with the disposal of the investment. There is always the possibility that the disposal of the investment may be at a lower price, or the company may not be able to dispose of it at all. There is also concentration risk, which is the risk of concentrated investment in the area where the organisation seeks to invest.
Another risk to consider is credit risk, where the issuer may be unable to pay the principal. Other investment risks include reinvestment risk and inflation risk, and horizon risk which is the risk arising from the inability of the investing company to retain the investment due to unforeseen circumstances. With so much to consider even before actually making the investment, companies should set in place proper frameworks and policies to guide their investment efforts and determine their risk tolerance. An ERM approach to managing investment risk is an effective one as it sets out the appropriate procedures in a practical, structured manner that is easy to use.
The ERM structure supports the company’s efforts at understanding its needs and constraints and sets out the best path for alignment of strategy, objectives and mitigative measures. ERM also stresses careful monitoring, constant review and adjustments for best results, together with clear lines of authority and accountability. This ensures transparency and good governance – the responsibilities of board and management as they make investment decisions with shareholders’ funds. Applying ERM to investment activities helps sustain these in the long term; long-term investing is in fact one of the strategies analysts suggest for investment risk management.
Appropriate risk management cannot be overemphasised, with the multiple challenges of increasing globalisation and complex, volatile markets. Companies which have made long-term investments in other jurisdictions, especially, will find managing risk more important than making profits, particularly if these are emerging markets. Social and political unrest may create economic turbulence in such environments, leading to uncertainty which will intensify market volatility. This calls for a deeper, more comprehensive understanding of the market, and clear, up-to-date information to support decision-making where investing is concerned.