i UNDERSTANDING INVESTMENT RISK jsk management is the process of mitigating the risks associated with investments by ing and managing those [Link] risk analysis refers to the arious investment of evaluating the potential risks associated with v: jt involves assessing the likelihood of different outcomes and potential -aportuniti¢ make well-informed ie crucial for investors seeking to aghieve their finance investment decisions. Understanding and analyzing es to ial goals while investment risks fective risk analysis provides insights into potential pitfalls, uncertainties. Eff nvestors to make proactive adjustments to their portfolios. The primary objes tives of investment risk analysis include; ng the possibility of significant financial losses return trade-off Vie. the ri ‘estment strategies with an individual's risk tolerance, and s the overall decision-making process. investing involves. a delicate balance between potential returns and associated risks. «analysis is essential for + jnyesinis understand that a comprehensive examining a range of factors that can impact net investment decisions. By ndividuals and institutions can strategize to maximize of the factors to consider anaes the performance of investment + seiqams while safeguarding against unnecessary losses. Some before making an investment include; isk— Risk refers to the uncertainty that your investments actual, different asset evel of scrlortmance might deviate from your expectations. As, such, ties, carry distinct, risk te, and commodil classes, such as stocks, bonds, real est i ‘ ne protites. The equities asset class,/ for instance, tends to have higher volatility compared to fixed income asset class. : i ‘ispeeted return - Expected return is a critical metric in investment analysis that rn from an investment over &,. V4 ‘quentities the potential gains an investor couldspecie period: H serves as a guide to estimate the average outcome, accounting ‘ar both positive and negative scenarios, By understanding the expected return, snvestors ean make more informed decisions that align with their financial goals and risk tolerance. iii, Liquidity - Liquidity refers to the ease with which an investment can be quickly converted into cash without significantly affecting its market price. Liquidity is a crucial consideration for investors, as it impacts your ability to access funds, respond to changing market conditions, and mandge unexpected financial needs. iv. Investment horizon - Investment horizon refers to the length of time an investor plans to hold an investment before needing to access the funds or achieve a specific financial goal. It is a fundamental consideration that influences the choice af investment vehicles, risk tolerance, and overall investment strategy. ! Understanding your investment horizon is essential for aligning your investments with your financial objectives his important to note that investing in any country involves risks, and the situation can change due to various factors including the expected economic growth both globally and locally, level of inflation, currency prospects, political developments and social stability. Scetion 2: Types of Investment Risks We will focus on the broad categories of investment risks, a) Systematic and, b) Unisystematie risks depending on their stemming sources. 1, Systematie Risks - These are market related risk which an investor cannot iti ate through diversification of the portfolio, Systematic risks are mainly caused by factors that are external to an individual or organization and are inter- related to macro-economic indicators such as inflation, Gross Domestic Product (GDP), exchange rate variability and interest rates. The various types of systematic risks include: '|, Inflation/Purchasing Power Risk Inflation refers. to persistent and sustained increase in general price levels, which consequently reduces the purchasing power of money. Inflation risk is, thus, the potential of reduction in the actual worth of an investment and its return owing to inflation, It mostly affects fixed income securities, as their income is fixed on nominal terms: The chart below shows inflation rates in Kenya over the years: ii. Interest Rate Risk — The risk arises as a result of changing interest rates in the market. Ary change in the interest rate as a result of market forces alters‘the:return on investments, mostly fixed income securities as bond prices for instance, are inversely related to the prevailing market interest rates, and, iii, Exchange Rate Risk ~ This is the risk arising from the fluctuation in the value of foreign curreney with respect to the local currency. Exchange rate tisk affects only the securities of companies or individuals with foreign exchange transactions or exposures, which affects the actual worth of such an investment, The table below shows the performance of the Kenya shillings against major ‘currencies, with the shilling having depreciated ‘against all the selected currencies:ace of the Kenya Shilling Against Select Currencies Jtonn Report: Performa ‘Currencies [ianwary 2023 (vs KES) | [Current TD change s USD re fi: TAY (USD 123.4 144.9 17.4%) UR 131.7 156.9 19.2%) lor 148.7 183.1 (23.1%) IPY p95 1.0 (4.3%) TSHS 10.05 lo.06 9.4%) Usiis (0.033 l0.039 (18.2%) [—Tnsystematie risks- refer 10 Fisks unique (0 @ particular company, individual, or industry and can be reduced to a certain extent by diversification. Unsystematic risks mostly arise from the management, location, or financial obligations of the investor, The various subdivisions of unsystematic risks include; Liquidity Risk — this is the possibility of not being able to convert an investment into ready cash when a need arises or the difficulty of finding a buyer in the market when one needs to liquidate their investment, ii. Financial Risks — refers to the uncertainty in the expected returns as a result of changes in the financial structure of a company. Only risk-free assets ive returns equal to their expected returns. An example of this risk is when 4 firm has no capacity to meet its business obligations and is therefore unable to pay dividends or even interest, iii. Political Risk~ This refers to risks arising from changes in legislation, trade barriers, or any other political decision that could have a negative impact on the projected rate of return from an investment, iv, Business Risk- This is the uncertainty in the returns of an investment due to volatility in a firm’s operating income,Legal Risk ~ Refers to the potential of a loss emanating from insufficient knowledge or misunderstanding of how the law applies to your investment, and, vi, Investment Manager Risk ~ It is the risk linked with the ineffectiveness and inefficiency of an investment manager's ability to manage risks prudently. Identifying Investment Risk Identifying investment There are many ways to measure investment risk, The most common are the standard deviation and the betastandard deviation is a measure of how much the returns from an investment vary from the mean, A high standard deviation indicates that the returns from the investment are scattered widely, while a low standard deviation indicates that the returns from ‘the investment are move tightly clustered around the mean. Beta is a measure of how much an investment's returns vary relative to the market as a whole. A beta of 1 indicates thatthe returns from the investment are exactly equal to the market's returns, while a beta of 0 indicates that the investment’s returns are completely independent of the market's returns. ¥ The two most important factors to consider when calculating investment risk are an ment's standard deviation and its beta. However, it's also important to consider an ii investinent's Sharpe ratio, which is a measure ofan investment's risk-adjusted return. iP An investment with a igh standard deviation and a low beta is likely to have higher risk than an invesunent with a lower standard deviation and a higher beta. An investment with a high Sharpe ratio is likely to have lower risk than an investment with a low Sharpe ratio. However i's not always éasy to determine which type of risk an individual investment poses. Vor exemple, an investment with a high standard deviation but a low beta may have less risk than an investment with @ low standard deviation and a high beta, but the first investment mY also have lower potential returns, Wei 4 consult with a professional financial advisor if youre unsure which type of Fisk amin individual investment poses.4, Measuring and Quantifying Investment Risk “There are a few basic questions you need to answer to quantify and measure investment risk: 1, What is the potential return on the investment? What is the potential loss on the investment? - What is the probability of the investment returning above its original value? _ What isthe probability of the investment returning below its original value? What is the probability of the investment not returning at all? How much money is at risk? a How much money could be lost if the investment fails? §, How long has the investment been in existence? 6, What other investments are available that could be used to hedge or offset any losses on the investment? 10. What is the level of risk you are comfortable with? 11, How much time do you have to make a decision about whether to invest in this particular investment? 12, What is your financial situation currently? 13. What is your time horizon for this investment? 114; Are you comfortable with taking on more risk for an increased potential return? 15. Are you comfortable with taking on more risk for a decreased potential return? 16, What factors would cause you to change your mind about this investment? 17. Do any outside factors impact your decision-making process when it comes to investing in Ahis particular asset class or type of security? 18. Are there any risks associated with this particular asset class oF tyPe of security that are not mentioned in question 16?10, How can you reduce or manage these risks? 39, What etTeet di i ‘eae 39, What effect does risk have on your decision to invest in this particular asset class or type of soourity? 21, Are there any other factors you would like to consider before making # decision about investing in this particular asset class or type of security? 22. Have you read and understood the risks associated with investing in this particular asset class or type of security? vou have any questions about how to measure and quantify investment risk? 23. Do .d with this 24, Do you have any questions about how to mitigate or reduce the risks associate particular asset class or type of security? 5, Managing Investment Risk ‘Managing your investment Managing investment risk rot pay off. There arg-different tyPes of Investment risk is the chance that an investment will investnent risk, including: 1. Market risk 2. Financial risk 3. Operational ri 4, Credit tisk 5. interest rate risk ; 6. Volatility risk 7. systematic risk 8 raphical risk 9, Political risk0. Legal risk Managing investment risk can be difficult, but it's important 10 remember that i esting Process. ii i investing process, There are a few things you ean do to minimize the ehances of investment 5 a part of the losses? M1 help 1, Choe you avoid investing in risky securities or products. s investments that you're familiar with and have a good understanding of Th 2, Make sue you have a sound financial plan in place. This will help you understand your risks and make smart decisions about which investments to make. 5, wy up to date on financial news and developments, This ‘vill help you better understand the sjaks associated with specific investments. 4, Don't overspend on unnecessary investments. Instead, focus on making sure that your investments are well-diversified and backed by sound business principles. 5, Be aware of your own emotions when investing. If something feels too good to be true, it probably is. Stick to conservative investment options that you know will pay off in the long run- Strategies for Minimizing Investment Risk Minimizing Investment ‘there is no singular answer 10 minimizing investment risk, as different individuals and biaineses will have different priorities and needs. However, there are a number of general sates tha ean be employed to help minimize risk. 1 tnderstand the risks you are taking: Before investing in any asset, it is important to anderstand the sisks associated with that asset. This includes understanding the risks associated sth the eompany the asset is associated with, understanding the risks associated with the asset isl and umelerstending the risks associated with the market in which the asset is traded. 2. Divesits your portfolio: One of the best ways to reduce isk is 10 diversify your portfolio. This mean investi 4 _ ‘ ji nica: investing in a variety of different assets, rather than focusing all of your money inTs ay _paycate yourselPabout investment risks: One of the best ways to reduce investment risk is to e yourself about Wvestment risks. This includes learning about the different tyPES of risks $ well as learning about how to assess fisk and manage it. {1 Monitor your portfolio regularly: One of the best ways to reduce investment risk 18 0 monitor sour portiolio regularly. This means tracking the performance of your investments and making chang ‘sto your portfolio as needed to keep it as safe and profitable as possible. 5, Exercise caution when investing in volatile markets: One of the dangers of investing in solatte markets is that you may experience significant losses if the market changes direction abruptly. As such, it is important to exercise caution when investing, in these markets and to make sure that you understand all of the risks involved. henefits of Effective Investment Risk Management Investment and Risk Management 1 ctteetive investment risk management helps protect investots from the potential losses that ean come from investments. > sick management techniques help investors make informed decisions about which investments to make and how much risk to take on. 3, Risk management helps investors limit the amount of financial capital that they need to put into ap investment, which can help them save money.amount of risk that they are taking on. |. Risk management techniques can also help investors make more money by reducing the 5 pitective investment risk management is an important part of overall finaneial planning. , ) & the henelits of elective investment risk management are significant and ean be seen in both short-term and long-term financial planning. :