2.4 Investment Risks

Risk Is Plural

Investors use "risk" to mean "the chance I lose money". The syllabus requires something more precise, because different risks have different causes, affect different asset classes, and call for different responses. Naming the right risk is routinely the whole content of an exam question.

Inflation Risk

Inflation risk, also called purchasing power risk, is the possibility that the return earned fails to keep pace with the rise in prices, so the money buys less at the end than at the start.

It is the risk that most investors ignore entirely, because the account balance never falls. A deposit compounding at 4% while inflation runs at 6% loses roughly 2% of purchasing power annually. It affects cash and debt most severely, and is the specific risk that equity exposure is intended to address over long horizons. Over a 20-year goal, inflation risk is larger than volatility risk — a conclusion many investors find counter-intuitive and which the syllabus asks you to defend.

Interest-Rate Risk

Bond prices move inversely to market yields. When yields rise, the fixed coupon on an existing bond becomes less attractive, so its price falls until its yield matches the market. The magnitude depends on duration: the longer the duration, the larger the price move for a given yield change.

Approximate price change  ~  - Modified Duration x change in yield

A fund with modified duration of 6 years facing a 1% rise in yields loses approximately 6% of value from that effect. This is why an overnight fund barely moves when rates change while a long-duration gilt fund moves a great deal. Interest-rate risk applies to all debt, including sovereign debt with no credit risk whatsoever.

Credit or Default Risk

Credit risk is the risk that a borrower fails to pay interest or repay principal when due. It also covers the intermediate case: a downgrade in the issuer's credit rating lowers the market price of its bonds even though no payment has been missed.

Credit risk rises as one moves down the rating scale from sovereign and AAA paper towards AA and A rated issuers. It is compensated by a higher yield, and the exam expects you to recognise that an unusually high yield on a debt scheme is a statement about its credit risk, not evidence of manager skill.

Liquidity Risk

Liquidity risk is the inability to buy or sell an asset in reasonable size at a fair price within a reasonable time. It has a cruel property: it is lowest when it is least needed and highest when it matters most. In calm markets almost everything trades; in stressed markets the buyers for lower-rated corporate paper disappear precisely when funds need to sell to meet redemptions.

It affects small-cap equity, lower-rated corporate debt and real estate most acutely. SEBI's stress-testing and liquidity-disclosure requirements for mid- and small-cap schemes exist specifically because of this asymmetry.

Concentration Risk

Concentration risk arises when too much of a portfolio depends on a single outcome — one stock, one sector, one issuer, one asset class, or in a debt fund one borrower group. A sector fund is concentrated by design; an investor with a single employer's stock, an employee stock option plan and a job at the same company is concentrated by accident and far more dangerously, because the income and the portfolio fail together.

Diversification is the direct mitigation, and it is the structural reason mutual funds exist at all.

Other Named Risks

• Market or systematic risk — the risk affecting the entire market, which diversification cannot remove.
• Currency risk — for schemes with overseas assets, the effect of exchange-rate movements on rupee returns.
• Reinvestment risk — the risk that maturing coupons or principal must be redeployed at lower prevailing rates.
• Business risk — the risk specific to one company's operations, which diversification does remove.
• Regulatory or political risk — changes in law, tax or policy altering an investment's economics.

Mapping Risk to Asset Class

The final row carries a distinction the examination returns to repeatedly: business risk is diversifiable, market risk is not. Holding fifty stocks removes the risk that one company fails; it does nothing about a broad market decline. That difference is what beta measures, and it is why a well-diversified fund still falls in a bear market.