We cannot simply enjoy the perks of any investments without considering the risk factors involved in it. Nearly every investment instrument in the world has an undefined level of risk associated with it. The level of risk can be different for each capital market and can be mitigated by taking appropriate steps.
New as well as some of the experienced investors in Nigeria often make the mistake of ignoring the risk factors associated with the concerned financial instrument. It is essential to identify each risk element and make a fortified financial plan to achieve the financial objective efficiently.
Potential investors should also acknowledge the asset allocation, risk tolerance, time horizon before making a financial plan, and making investment decisions.
Following are the common types of risks that can drastically affect your investments and are responsible for volatility.
1. Market Risk
Profits can be booked in any of the financial markets if the market behaves in favour of the investor. Although, the markets can also react in the opposite direction which may provide losses to the investor. Market risk is the most common risk that exists in most of the capital markets.
The severity or magnitude of the market risk depends upon the volatility or the profit-making ability of the capital market.
Trade Forex Nigeria explains that “Different financial markets carry different risks for the investors, forex market has higher risks than any other markets. This risk is amplified multiple times by leveraged financial instruments.”
“Complex financial products and leveraged financial instruments that have potential to offer higher ROI in short-term like derivatives, CFDs etc. carry a very high market risk; while instruments that offer low ROI like government bonds and other fixed income securities involve lesser market risks as they are secured by trusted entities like Governments and Corporations.”
Market risks can be mitigated through diversification by investing in different assets, by balancing investments in different low & high-risk instruments and different sectors. You can also keep more low risk investments in your portfolio to minimise the risk.
2. Liquidity Risk
In financial markets, liquidity depicts the ease at which the owned asset or security can be converted into cash.
Not every capital market allows the investor to buy or sell the instruments at any moment. This inability to buy or sell the financial instruments at a fair price at the desired time is referred to as liquidity risk.
The seller might have to agree to sell at lower prices while the buyer has to pay higher prices due to liquidity risk, because there is not enough liquidity in the market.
Read Also: Need for Nigeria to domesticate renewables value chain
The liquidity risk exists due to a lack of buyers or sellers in any of the markets or inefficiency of the market. If the buying and selling cannot be done at the desired time, then orders cannot be executed at the desired price.
The investors must check the associated liquidity risk before making investments in any of the capital markets.
3. Concentration Risk
If the whole investment amount is focused on one element of a single instrument, then there is a higher probability of facing severe losses.
However, if there is a large variety of financial instruments in the portfolio then the correlation of the returns is reduced. In other words, the losses of some of the instruments will be cancelled out by the profits in other tools and there is a less probability of facing unwanted outcomes.
Investors need to ensure that their investment portfolio is well-diversified and involves different types of financial instruments from various sectors, industries, counterparties, and countries. For example: An Investor in Nigeria can diversify investment between NSE stocks, government bonds & Fixed Deposit Account.
It must be noted that over-diversification of the portfolio might suppress the potential gains from a portfolio.
4. Inflation Risk
Inflation is the rise in the price or reduction in the buying power of money over a prolonged time period. Most of the investments are done to counter inflation and maintain the buying power of the money owned by individuals.
However, the consistent rise in the price or inflationary environment might overlap the returns provided by the chosen financial instrument. This might lead to a reduction of buying power of the investment amount or lesser gains than anticipation.
Bonds and fixed income securities are the most prone to inflation risk due to low returns. Investors in Nigeria must ensure that the chosen financial instrument has a higher return rate than the potential inflation rate in the future.
5. Business Risk
Every investment done in any of the capital markets is received by an entity that can either be a business, person, government, or institution. However, these entities can sometimes fail to deliver the expected outputs due to multiple reasons.
The inability of the entities to perform can result in fatal outcomes for the investors which are regarded as a business risk in finance. This type of risk exists in almost every capital market but can be mitigated by choosing a trustworthy entity for investment.
6. Political Risk
The government and its policies can greatly affect the price movements of financial markets. International relations, trade barriers, taxation policies, legislation, and administrative restrictions play an important role in guiding the price movements of capital markets.
If any of the policies or decisions made by the government goes against the concerned financial market or sector, then it will negatively affect the price movements of the financial instrument.
Investors should watch out for the impact of government policies on the chosen instrument to mitigate political risk.
7. Horizon Risk
The investment you made for the long term might need to be withdrawn before the expected time horizon in case of an emergency. The premature withdrawal might have a negative impact on the invested amount or penalty fees can be deducted from some of the capital markets.
Most of the bonds and fixed income securities charge penalty fees for premature withdrawals. The risk of facing unwanted losses or penalties due to withdrawals made before the expected time horizon is called horizon risk.
8. Reinvestment Risk
It is the risk of not being able to re-invest the coupon payments or the withdrawn amount due to the unavailability of a similar or better investment option. To upkeep the buying power and enhance the value of the money earned after investment, it is important to reinvest the withdrawn or gained amount in a similar or better investment tool.
Financial instruments that have short maturity tenure or generate regular coupons are prone to reinvestment risk.
9. Third-Party Risk
Also known as counterparty risk, third party risk is the risk that is directly related to the broker or the investment manager. If the broker or the investment manager is unregulated, not qualified or licensed, it can be fatal for the investors as the counterparty can use the investment amount for self-interest.
Apart from this, if the investment manager follows an investment style that is not suitable for the investor, this will also incur third party risk as the investor might not be able to attain suitable outcomes.
To mitigate the third-party risk, investors need to make adequate efforts to check the reviews, regulations, and licenses of the broker or the investment manager.
10. Foreign Investment Risk
Investments made outside the Nigerian jurisdiction depend upon the market trends, economy, and currency fluctuations of the country in which the investment has been made. The local government and international policies affect the price movements of such capital markets which can be difficult to track for individuals in Nigeria.
The risk of facing volatility in the investments due to foreign investments is called foreign investment risk. The individuals in Nigeria should avoid allocating a large proportion of the investment amount in a foreign capital market.
Bottom Line
Investors in Nigeria should spend adequate time and effort in analysing the potential risk factors in the chosen capital market and take the required steps to mitigate the risk.
It is important to understand all the risk elements that can affect your investment to have a resourceful and convenient investment experience. Investors must ensure whether they can afford to take the concerned risk or not before making the investments.
