What is Risk in Finance?

“Risk” is a general term that is used in different contexts. It can be defined as the probability of an outcome not coming out as expected, usually in the negative. In finance, risks mostly have to do with the possibility of occurrences that could happen contrary to what was expected especially during investment. 

There are always risks involved with any kind of investment or business. These risks come in various forms such as inflation risk, market risk, investment risk, liquidity risk, business risk, and other external factors that can trigger risks. Before getting into any market for business or investment purposes, the risks must be highly examined and understood.

“Risk is the possibility than an outcome will not be as expected…”

Understanding What Risks means in Investing  

Risks are a part of human life that encompasses everything we do from walking down the street to investing or doing business with an unknown seller over the internet. Everyone experiences risk daily whether they are planned for or not. 

While we may all experience risks daily, we do not all have the same risk tolerance. Some people have high-risk tolerance while others have a low-risk tolerance. As an investor, your personality, lifestyle, and other top factors say a lot about what kind of investor you are, in terms of risk tolerance and investment management. Every investor has a risk profile that is particular to them. 

All investments are prone to risk, some higher than others. The more an investment’s risk, the more investors expect the returns to be higher as compensation for the high risks. Investors that fall under this category have a high-risk tolerance. While investors with low-risk tolerance will rather not get involved with high-risk investments no matter how appealing the returns are. 

“Your Risk Level is how much risk you are willing to accept to get a certain level of reward; riskier stocks are both the ones that can lose the most or gain the most over time.”

The relation between risk and return is a fundamental concept in finance, in that, the greater the risk involved in an investment, the greater the potentials of returns. This serves as compensation for investors who are willing to take up highly risky investments. A typical example is comparing the U.S. Treasury bond with a corporate bond. The U.S. Treasury bond is a safe investment that guarantees investors of their investments, however, the returns are low. On the other hand, corporate bonds are considered as high-risk investments that are most likely to go bankrupt, however, they offer high return rates to compensate investors.

How to determine your risk level

As earlier stated, your personality, lifestyle, and other top factors determine your risk tolerance level. It is possible to have low-risk tolerance yet you are willing to risk a few high-risk investments. We’ve outlined some guidelines that will help you determine your risk level and serve as guidelines for your risk-taking.

• Liquidity: Depending on how soon you intend to liquidate your investment or how long you intend to keep it, determining the liquidity of an asset will help you wisely select your investment. For example, stock investments are considered very liquid because they can be sold at any time during trading hours. While investments like real estate are considered fairly illiquid because it can take up to a year or more to get good returns on the investment. 

• Investment knowledge: Good investment knowledge will help you make well-informed decisions about your investments. The more investment knowledge you have, the more high-risk investments you will be willing to take. With good investment knowledge, you will know how to protect yourself and also have a better idea of the risks involved.

• Risk aversion: This usually is the major factor in determining your risk tolerance level. It measures how comfortable you are with risk. High-risk aversion means that you do not mind investing in a stock that has gained 20% but has only lost 5% at most per time. Moderate risk aversion means that you are okay with investing in a stock that could have 70% gains but can lose 20% regularly. Low-risk aversion (,) means that you prefer to invest in a stock that has a possibility of 200% gains but could also lose 100% regularly.

• Economic outlook: This is considered as an important factor. If the economy is affected by the slightest pressure or crisis it could take a turn on the markets. A positive economic outlook will allow investors to increase their risks. However, a negative economic outlook would cause investors to lower their risk levels.

Assessing Risks in Finance

Risks are assessed by considering historical patterns, behaviors, and outcomes. Standard deviation is a common metric used in assessing risks in finance. It aids in measuring the volatility of a value, comparing it to its historical average. A high standard deviation shows high-value volatility which will result in high risk.

Once risks have been assessed and identified, all parties concerned such as companies, financial advisors, or individuals can develop risk management strategies to help manage the identified risks. Over time, other strategies, theories, and metrics have been developed to identify, assess, measure, analyze, and manage risks. Some of them include: Value at Risk (VaR), Capital Asset Pricing Model (CAPM), beta, and standard deviation.

The overall purpose of measuring and quantifying risks is to allow investors, business managers, and traders to identify and hedge some risks through the use of various strategies such as derivative positions and diversification.