Being clear about how to measure investment risk is essential in the consolidation of business growth projects, since it serves as a starting point to make the right decisions based on the needs and possibilities of the company.
In order to have greater control over an investment, it is important to evaluate the possible risks and their magnitude, since in this way the impact that it will have on the project, on the capital, the people involved and the direction that said investment will follow can be measured.
Becoming aware of this risk leads to being more selective in the investment projects to be carried out.
In this article Blue World City will tell you in detail everything you need to know about investment risks, what types exist and some tips to minimize them.
What is an investment risk?
An investment risk can be defined as the probability that a return is lower than expected, in simple words it would be that the investment made does not provide the expected return or that the loss exceeds the initial investment.
Taking this definition as a basis, we can mention that every investment carries a risk, no matter how minimal, and that the greater the investment, the greater the risk.
Now, there are ways to prevent these risks and secure our investment. To do this, you must be clear about the types of risks to identify those that threaten your investment first-hand.
Investment risk levels
Among the various ways that exist to classify an investment by its level of risk, this is the most common and easiest to explain from an investor’s point of view.
1. Low risk
At this level the chances of loss or non-payment are low. It can occur in deals carried out with banking or government institutions, which tend to have greater stability and are more reliable.
Although they provide greater security to your investment, they usually grant few profits, this level is ideal when you want to keep your capital safe and generate some profit without this being the priority.
2. Medium risk
Unlike low risk, a greater part of the capital is invested at this level, which implies a greater commitment and a more detailed analysis of the situation.
At this level the profits are considerable, it requires having knowledge of the operation and the markets in which it operates. Some examples of medium risk investing are debt bonds or real estate.
3. High risk
It is the level that provides the highest returns; however, it is more volatile and the risk of non-payment or bankruptcy is higher. Some examples of this are stocks, currencies, or derivatives.
Expert investors who make investments at this level are prepared with the information and remain active throughout the operation. One of the countermeasure strategies to minimize risks is to have a loss containment plan.
Types of investment risks
Once we have cleared the risk levels, we will talk to you in more detail about its classification, to minimize the chances of losing money with a bad deal.
1. Systemic or market risk
Market or systemic risk – also known as systematic risk and non-diversifiable risk – is the one that directly affects the market regardless of the company where the investment has been made, for example, the events of 2020 derived from the pandemic and other similar events that affected the world economy generating times of crisis for many countries.
The factors that help you measure market risk are:
- The price of the shares
- Interest rates
- Currency exchange rates
- The price of raw materials
The volatility of this type of risk is affected by these 4 factors and the magnitude and speed at which they can occur affect prices in the market.
2. Non-systemic risk
Also known as diversifiable risk, it is a type of risk that affects a specific company, conditioned by its own factors and that only affect the profitability of its share or bond.
Some examples of this can be the bad business results derived from a contract, sales data below expectations, a new product from the competition, fraud, poor management, among others.
3. Liquidity risk
We can define liquidity as the ease that an asset has to convert into money, so liquidity risk occurs when a company has to sell its assets below market value.
On the other hand, it also refers to the ability of a person or company to meet their short-term obligations.
Liquidity risk can be measured by liquidity ratios, the main ones being current assets and short-term debts. It is possible that a company has sufficient long-term assets or investments to cover the amount of its obligations but not immediately.
We can classify liquidity risks into two main ones:
- Asset liquidity: when assets have the ability to be operated, that is, the company’s products and services are easily traded and, if necessary, to settle debts even below their price.
- Fund liquidity: when one of the parties involved in the operation does not have the funds to pay its obligations.
4. Credit risk
It is also known as default or counterparty risk; it refers to the inability of the counterparty to assume its obligations after it has been lent money.
In most cases, it is the banking institutions that have the greatest possibility of running this risk, therefore, to minimize it, studies are carried out that support the liquidity of the entity that requested the loan.
5. Legislative risk
This risk goes hand in hand with the government, which can create, modify or eliminate certain laws that affect the operation in which capital has been invested.
One measure to reduce the chances of this is to invest in stable countries with established laws that are not pending enactment; in this way you will protect your capital.
6. Interest rate risk
It is considered a systemic risk because it is subject to changes and variations in interest rates in the market. Although it can impact all types of assets, those most at risk are fixed income investments, such as bonds or preferred stocks.
7. Inflation risk
This type of risk will depend on the economy, if the inflation rate grows the risk that it exceeds the profitability of your investment also increases. This can impact the acquisition capacity of the company and that the return on investment is lower than expected.
How to measure the risk to invest?
The best way to know the risks of an investment is through quantifiable indicators such as volatility, profitability or return. However, there are different methods to evaluate them and choosing the most appropriate will depend on the approach taken.
Choosing the most convenient method to assess the risks of an investment will be the starting point for calculating the Value at Risk (Var), an indicator that allows quantifying the financial risk to which an investment will be exposed.
Using this statistical technique, you can determine the probabilities – usually between 1 and 5% – of suffering a loss during a period of time, be it a day, a week or a month.
There are 3 ways to calculate Value at Risk (Var):
- Parametric Var It is calculated using estimated profitability data and assumes a normal profitability distribution.
- Historical Var It is based on previously generated returns, so its biggest disadvantage is that it is assumed that these will be repeated in the future.
- Var for Monte Carlo. It is calculated through computer software that generates a large number of possible results according to the initial data entered by the user.
Taking this as a basis, we will tell you in more detail about the methods for evaluating the risks of an investment.
Traditional method of evaluating the risks of an investment
The traditional method prioritizes the volatility of the asset to be evaluated through statistical data such as the dispersion of returns; it is an indicator that measures the degree to which an asset’s historical returns deviate from its average rates of return.
In general, it is measured as a standard deviation to determine how likely it is that this return will vary considering the past data for a given period.
To calculate the deviation, it is necessary to know the costs that have been recorded in an asset to determine what their variance has been with respect to the mean, and thus, have precise data on the dispersion to which the asset to be invested will be exposed.
Fundamental method for evaluating the risks of an investment
This approach is based on the value of the business as such, therefore the historical behavior of prices is not an indicator of risk, on the contrary, if they fall, it represents an investment opportunity, as long as the economic fundamentals of the business (supply and demand, economic cycle, etc.) have a positive behavior.
The real estate market, for example, is a sector that stands out from other investment opportunities due to the stability that its economic fundamentals have maintained and its importance within modern economies, in terms of income and investment.
It is a sector that, even in times of crisis, has generated higher returns than other investments. It is estimated that, after the 1994 economic crisis, property prices increased by 507% on average, exceeding inflation growth, which at that time was 373%.
This trend is currently repeated in regions such as the Mexican southeast despite the uncertainty that the country is experiencing, since during the first quarter of 2019, the real estate supply in Quintana Roo and Yucatán increased by 282% and 234%, respectively.
This growth has had a positive impact on property costs. While housing costs in Quintana Roo increased 11%, in Yucatan prices increased 9.1%, exceeding the national average.
Assessing the risk of an investment using a fundamental analysis requires extensive knowledge of the industry and the company that supports the project in question, otherwise, you are exposed to a poor evaluation of your economic fundamentals.
Tips to minimize the risk of an investment
Now that you know the types of investment, how they are classified and the methods to evaluate them, we leave you some tips that will help you invest safely and minimize risks.
- Know the investment assets: Having sufficient knowledge of the market in which you are going to invest and its assets will help to effectively measure the Var as well as calculate the return on investment (ROI) and ensure that it is convenient to invest.
- Anticipating the future: We understand that it is not possible to predict what will happen with certainty, however, being aware of political, economic and social events in the country and the entity where you want to invest will help to anticipate possible risks and what so viable is it to carry out an operation that is successful at that moment.
- Diversify risk: It is vitally important to diversify investments in such a way that a balance is reached between low risk and high risk, this is known as the golden rule among expert investors.
- Evaluate results: It is important to be aware of the evolution of the operation and evaluate the results, to implement measures that allow building a better strategy in future investments.
- Use of tools for financial risk management: An example of this is the contracting of insurance, which is possible for certain types of assets. You can also apply protection policies such as a privacy notice that guarantees the security of your project.
Real estate sector: the best investment opportunity
Investing in real estate guarantees your investment as it is a medium risk operation and is one of the safest options that provide opportunities to generate extra income, in addition to protecting your capital from inflation and granting legal certainty.
The Mexican southeast has seen an increase in real estate investments carried out by nationals and foreigners, opening the opportunity to venture into this type of investment projects and obtain profitable income.
Hiring a serious company, with experience and a leader in the real estate market that guarantees your investment with market studies that guarantee profitability in the medium and long term will be a key piece to make your money grow.
We are BMF Inversions and we have more than 25 years of success in real estate projects such as investment lots in the best commercial areas of cities in the Mexican southeast.
The commercial land in Cancun, Merida and Playa de Carmen are the guarantee of a profitable business.