While sipping a refreshing brew of morning coffee at a local cafe, you flip past the front page news on the Greek debt crisis. An article on a local Singapore coffee company stealing Nestlé Nespresso market share catches your attention.
This is the type of tangible investment famed value investor Warren Buffet loves – from Fruit of the Loom underwear to the Wrigley’s gum and Cherry Coke he loves. You open up your investment app and buy 100 shares in the company.
By mid-morning, Greece is all over the news. Analysts have raised the country and political risk on Greece as the new president threatens to default on its loans. Foreign exchange traders flee to safety by selling the Euro and buying the Singapore dollar.
News reports state the Singapore monetary authorities, now fearing inflation from an overvalued dollar, will raise interest rates to make it more expensive to borrow money. The Singapore coffee shop can no longer afford to borrow money to finance its expansion into other Asian markets. Its stock price stagnates.
By lunchtime, your investment has been affected by six types of investment risks – all triggered by a crisis in Greece. Because you are investing in a global market in which economies are linked, a political ripple in Europe can affect the prices of Singapore stocks in your investment portfolio.
Investment risks to watch out for
Here’s a closer look at the risks that affect your investment portfolio.
Credit Risk is the risk of a company, government or individual being unable to make payments on principal and interest on borrowed money. Government bonds are considered investment grade securities because governments have a good track record of making debt payments.
The bonds of issuers with a high default risk – or lack of liquidity to make payments on debt – are called junk, or non-investment grade bonds. Credit rating agencies provide credit scores so potential investors and lenders can assess investment risk. AAA is the highest rating while junk bonds are rated BB/Ba or lower.
Foreign exchange risk
When investing in foreign assets – such as stocks, bonds, and real estate – currency exchange rates will affect the value of your investments. Online investing makes it easier than ever to invest in assets all over the world.
If your domestic currency is the Singapore dollar and you buy shares on the Hong Kong Stock Exchange in China Mobile, if the Singapore dollar depreciates against the Hong Kong dollar, the value of your investment will decline. China Mobile’s performance will also be affected by its own currency risk as a company that buys and sells products and services globally.
Interest rate risk
Interest rates represent the cost of borrowing money. Bond investing is very sensitive to changes in interest rates. On a macro level, all investments are affected by changes in interest rates to some extent.
When monetary authorities raise the rate of funds – the overnight cost of borrowing money – the cost of borrowing money is raised, whereas a decrease in interest rates makes it cheaper to borrow money, and thus increases money supply in the economy. The increase or tightening of interest rates slows economic growth while a decrease or loosening stimulates economic growth.
Market risk reflects daily fluctuations in the price of stocks and options. The variation in the price of a financial instrument over a period of time is called volatility. High volatility stocks are higher risk. Low volatility stocks are safer, long-term investments. Short-term traders prefer high volatility, providing them with more opportunity to profit from changes in prices.
Country risk should be considered in emerging market investments, but even developed countries can face risks in the business environment. Greece, for example, has faced a high default risk on its debt in recent years. All types of investments are subject to country risk.
Commonwealth countries Britain, Canada and Australia have the lowest country risk, while Africa has the most countries with high country risk. Country risk is very sensitive to changes in the business environment. Saudi Arabia’s country risk has increased while oil prices have fallen.
Political instability or the risk of political change is a greater risk in emerging markets, but as Greece’s debt crisis demonstrates, political stability can also hit developed markets.
How the different types of investment risks are weighted depends on the type of investments being analysed. A stock investment has more exposure to unsystematic risk, which are risks that affect a certain investment or asset class. The focus of your investment analysis will be on fundamentals (earnings, sales, cash flow, etc), competition, industry developments, credit risk, and so on.
The return on bonds or real estate investment trusts is directly linked to interest rates. Stock in an oil company exporting energy from foreign subsidiaries will be subject to currency risk and likely emerging market country and political risk.
In reality, company and industry fundamentals rather than the Greek default drama will influence your investment decision in the new coffee company. The example of risk spreading globally, though, is a daily occurrence.
Spreading your money across a portfolio of different investments is the best way to manage these risks.
This article first appeared in thenewsavvy.com
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