We all have a natural aversion to loss, but often tend to ignore the trade-off between risk and reward. Put simply, higher returns only come with higher risk, and if you substantially reduce risk you must accept lower returns. There are no free lunch of higher return and lower risk. The key is to finding your comfort zone on the risk/return spectrum and accordingly creating your investment plan.
Thus we can say that every investment entails some kind of risk and most investors are willing to take on some risk in exchange for greater returns. Below are three of the most common risks:
- Credit Risk describes the possibility that the counterparty will not meet its obligations. For example, a bond issuer will not pay the interest or principal to bondholders. Credit risk is usually greatest for financially weak companies or unstable foreign government.
- Market risk describes the day-to-day fluctuations in an investment’s price. These fluctuations may result from factors inherent in the investment, such as company’s announcement of change in management, or circumstances in the financial sector such as a bear market.
- Foreign Exchange Risk describes the possibility that fluctuations in currency-exchange rates will affect an investment’s value. Stocks in foreign markets are traded in their local currency. If that currency strengthens against the rupee, for example, the foreign stock’s value will increase.