The most basic relationship in finance is that between risk and return, the higher the expected return, the higher the risk one assumes in the investment and vice-versa. Stocks, for example, have higher returns than say, treasury bills because stocks’ returns are more volatile than treasury bills.
The reality is risks cannot be eliminated…they can only be managed well at best. Hence, one must have some basic concept of risk management to minimize the likelihood of bad investments. Managing our investment risks as individual investors need not be rocket science. We just need to understand the basic concepts of risk and apply certain common sense approaches to manage them better.
Risk is simply the chance or probability that something expected may not happen. In the context of investments, risk usually refers to either the chance or probability of losing money, not being able to immediately liquidate, i.e. convert into cash the investments made or both. To this extent, 3 of the more significant investment risks are credit risk, market risk and liquidity risk. Credit and market risks are concerned with losing money and liquidity risk is concerned with being unable to immediately convert our investments into cash.
Credit risk is the possibility that people or institutions that borrowed our money may not be able to pay us back. We may think that because we do not lend money directly, we are not subject to credit risk. Such is not the case. When we deposit our money in the bank, it becomes a payable of the bank and a receivable on our end. When we invest our money in government securities, e.g. Treasury Bills and Bonds, we actually lend to the national government. When we invest in commercial papers of established companies like Ayala Corporation, San Miguel Corporation and the like, we are in effect extending credit to them. And whenever we lend money, we are exposed to credit risk.
Market risk is the possibility that we may lose money on our investments due to movements in market factors such as interest rates, foreign exchange rates or market prices of stocks and similar investments. For OFWs, the most important market factor is the foreign exchange rate. When the peso appreciates, i.e. less Php for every unit of a foreign currency, bad news. When the peso depreciates, i.e. more Php for every unit of a foreign currency, good news. The OFW makes or loses money depending on the direction (appreciation or depreciation of the Php) and extent (amount of depreciation or depreciation of the Php) to specific currencies.