English
Risk is embedded in every investment. And if you want higher returns, you typically have to accept higher risks. That’s why U.S. treasury bills – backed by the “full faith and credit” of the U.S. government – pay out less than corporate bonds, which are subject to the financial health of that company, a riskier prospect.
Every investor has a certain risk appetite, or level of uncertainty they’re willing to take on.
This usually comes down to personal factors – are you young and willing to take on big risks, or do you need to ensure that your money will be around for retirement? Ultimately, we cannot eliminate all risks. We can however understand them and devise strategies to make them tolerable.
In this post we’ve highlighted five core risks every investor must grapple with, along with some tips on how to reduce them.
This is also known as systemic risk, because it involves sweeping risks that can affect an entire market.
When an economy suddenly plunges into recession, or a country is destabilized by political turmoil or struck by a natural disaster that decimates economic output, these are all examples of risks that could tank your investment.
Whether you hold stocks, real estate or commodities, most assets are subject to general market risk.
- Example: During the 2008 financial crisis, the S&P 500 dipped almost 50 percent in just six months as a U.S. housing market collapse turned into a global economic crisis affecting banks and investments worldwide.
- Mitigation tip: Diversify! Market risk affects a broad sweep of assets, but if you spread your investments across different geographies and industries you are less likely to sink when any one economy or market hits a crisis.
- Fun fact: Sukuk are less correlated with traditional assets and fared better during the 2008 global economic crisis than most other assets. This is because they are tied to tangible assets and not the creditworthiness of financial institutions or speculative instruments.
Read more about: Comparative Analysis: Sukuk Funding Vs Traditional Financing
This is the risk that you won’t be able to sell your investment in a timely fashion, often because it’s a market with a small number of buyers.
Ultimately you may have to lower the price and incur a loss. The most common example is real estate, when homeowners have to slash their offering price to find a buyer. But liquidity risks pop up in all sorts of assets, particularly more niche or smaller ones, like small-cap stocks.
- Example: The U.S. corporate bond market was hit by a major liquidity crisis during the Covid-19 pandemic as investors rushed to sell their bonds at once and found a shortage of buyers and liquidity drying up.
- Mitigation tip: Make sure that a healthy portion of your investments are in liquid assets like large cap stocks or ETFs.
Avoid having too much of your money concentrated in hard-to-sell assets like real estate, small cap stocks or certain bonds. Consider holding a portion of your portfolio in cash or cash equivalents like money market funds so you can quickly tap cash if the need arises
This is also known as default risk, or the possibility that your counterparty won’t meet their financial obligations. This often comes up with debt investments, like loans and bonds. In this case you’ve lent out the money, but the government or company that issued the bond is not paying the amount back in full.
- Example: The Covid-19 pandemic hit state finances across the globe, with seven countries defaulting on their foreign currency debt (Belize, Zambia, Ecuador, Argentina, Lebanon and Suriname twice). S&P Global Ratings has warned that countries are likely to default more frequently in the coming decade amid higher debt levels and increasing borrowing costs.
- Mitigation Tip: There’s no substitute for thorough due diligence. Understand your borrower’s creditworthiness by analyzing financial statements, credit ratings and industry trends.
You might also limit how much credit you extend any single borrower. Consider insurance to protect against borrower default if possible.
- Fun fact: Sharia-compliant structures like Murabaha tend to reduce the risk of default because they are backed by assets that serve as collateral.
Read more about: Your Basic Guide To Commodity Murabaha
This is the risk that your investment will not keep pace with inflation, creating a loss. It’s also known as purchasing power risk, because it means your money cannot keep up with rising prices, reducing your purchasing power.
- Example: You put your money into a savings or current account that offers no return. If inflation is 5 percent this year, your savings are worth 5 percent less, even though your money is safely stowed away at the bank.
- Mitigation Tip: Make sure your portfolio includes some investments that tend to outpace inflation, like real estate, sharia-compliant equities, or even gold, a popular hedge against inflation.
Read more about: Measuring Nominal Vs. Real Investment Returns
Changing interest rates can have a serious impact on your investments. While Islamic finance avoids interest (riba), the interest rate environment itself can alter the profitability of assets across the board, even those that don’t pay out interest.
When interest rates rise, assets with existing rates or lower returns are seen as less attractive, reducing demand for them.
Interest rates also affect consumer behavior, since higher interest rates make it harder for consumers to borrow money and spend. And companies may find it harder to pay back their debt, with higher debt servicing costs reducing profitability.
- Example: You’re invested in a Real Estate Investment Trust (REIT). Suddenly central banks start hiking rates. REITs that rely on debt financing will see their profits shrink, which will push down the price of the REIT.
- Mitigation Tip: If you think rates are likely to rise, prioritise investing in low-debt companies that are less vulnerable to rising borrowing costs. Consider investing in floating-rate instruments, like floating rate sukuk, which tend to move in line with conventional interest rates while still avoiding riba.
Read more about: What Are The Available Riba-Free Loans in the UAE?
Disclamer:
This post is for educational purposes only, and does not constitute investment advice or a solicitation to take any financial action. It should not be relied upon when making investment or financing decisions.
