Understanding Financial Risk in Investments
What is Financial Risk?
Risk is defined in financial terms as the chance that an outcome or investment’s actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment.
Basics of Investment Risk
Each investor has a unique risk profile that determines their willingness and ability to withstand risk. In general, as investment risks rise, investors expect higher returns to compensate for taking those risks.
Key Takeaways on Risk
- Risk takes on many forms but is broadly categorized as the chance an outcome or investment’s actual gain will differ from the expected outcome or return.
- Risk includes the possibility of losing some or all of an investment.
- There are several types of risk and several ways to quantify risk for analytical assessments.
- Risk can be reduced using diversification and hedging strategies.
Understanding Riskless Securities
These types of investments offer an expected rate of return with very little or no risk. Oftentimes, all types of investors will look to these securities for preserving emergency savings or for holding assets that need to be immediately accessible.
Risk and Investment Time Horizons
Time horizons are an important factor for individual investment portfolios. Younger investors with longer time horizons to retirement may be willing to invest in higher-risk investments with higher potential returns. Older investors would have a different risk tolerance since they will need funds to be more readily available.
Morningstar Risk Ratings Explained
Morningstar is one of the premier objective agencies that affixes risk ratings to mutual funds and exchange-traded funds (ETFs). An investor can match a portfolio’s risk profile with their own appetite for risk.
Types of Financial Risk
- Systematic risk, also known as market risk, is a risk that can affect an entire economic market overall or a large percentage of the total market.
- Unsystematic risk, also known as specific risk or idiosyncratic risk, is a category of risk that only affects an industry or a particular company.
Business Risk
Business risk refers to the basic viability of a business—the question of whether a company will be able to make sufficient sales and generate sufficient revenues to cover its operational expenses and turn a profit.
Credit or Default Risk
This is the risk that a borrower will be unable to pay the contractual interest or principal on its debt obligations. An example is government bonds.
Country Risk
Country risk refers to the risk that a country won’t be able to honor its financial commitments. This risk applies to stocks, bonds, mutual funds, options, and futures that are issued within a particular country.
Foreign Exchange Risk
This risk arises when investing in foreign countries due to fluctuations in currency exchange rates.
Interest Rate Risk
Interest rate risk is the risk that an investment’s value will change due to a change in the absolute level of interest rates, the spread between two rates, the shape of the yield curve, or any other interest rate relationship.
Political Risk
Political risk is the risk an investment’s returns could suffer because of political instability or changes in a country.
Counterparty Risk
Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation. This risk exists in credit, investment, and trading transactions, especially for those occurring in over-the-counter markets. Financial investment products such as stocks, options, bonds, and derivatives carry counterparty risk.
Liquidity Risk
Liquidity risk is associated with an investor’s ability to transact their investment for cash.
Risk vs. Reward in Investing
The risk/reward ratio marks the prospective reward an investor can earn for every dollar they risk on an investment. Many investors use risk/reward ratios to compare the expected returns of an investment with the amount of risk they must undertake to earn these returns.
Risk and Diversification Strategies
Diversification is a strategy that mixes a wide variety of investments within a portfolio in an attempt to reduce portfolio risk. This consists of different types of securities from diverse industries that have varying degrees of risk and correlation with each other’s returns.
Related Financial Terminology
The Bottom Line
The bottom line refers to a company’s net income, which is presented at the bottom of the income statement. It signifies a company’s earnings, profit, net income, or earnings per share (EPS). The reference to the bottom line describes the relative location of the net income figure on a company’s income statement.