What Is 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.

Quantifiably, risk is usually assessed by considering historical behaviors and outcomes. In finance, standard deviation is a common metric associated with risk. Standard deviation聽provides a measure of the volatility of asset prices in comparison to their historical averages in a given time frame.

Overall, it is聽possible and prudent to manage investing risks by understanding the basics of risk and how it is measured. Learning the risks that can apply to different scenarios and some of the ways to manage them holistically will help all types of investors and business managers to avoid unnecessary and costly losses.

1:17

Understanding Risk And Time Horizon

The Basics of Risk

Everyone is exposed to some type of risk every day 鈥 whether it鈥檚 from driving, walking down the street, investing, capital planning, or something else. An investor鈥檚 personality, lifestyle, and age are some of the top factors to consider for individual investment management and risk purposes. Each investor has a unique聽risk profile聽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.

A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk an investor is willing to take, the greater the potential return. Risks can come in various ways and investors need to be compensated for taking on additional risk. For example, a U.S.聽Treasury bond聽is considered one of the safest investments and when compared to a聽corporate bond, provides a lower rate of return. A corporation is much more likely to go bankrupt than the U.S. government. Because the default risk of investing in a corporate bond is higher, investors are offered a higher rate of return.

Quantifiably, risk is usually assessed by considering historical behaviors and outcomes. In finance, standard deviation is a common metric associated with risk. Standard deviation聽provides a measure of the volatility of a value in comparison to its historical average. A high standard deviation indicates a lot of value volatility and therefore a high degree of risk.

Individuals, financial advisors, and companies can all develop risk management聽strategies to help manage risks associated with their investments and business activities. Academically, there are several theories, metrics, and strategies that have been identified to measure, analyze, and manage risks. Some of these include: standard deviation, beta, Value at Risk (VaR), and the Capital Asset Pricing Model (CAPM). Measuring and quantifying risk often allows investors, traders, and business managers to hedge some risks away by using various strategies including diversification and derivative positions.

Key Takeaways

  • 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.

Riskless Securities

While it is true that no investment is fully free of all possible risks, certain securities have so little practical risk that they are considered risk-free or riskless.

Riskless securities often form a baseline for analyzing and measuring risk. 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.

Examples of riskless investments and securities include certificates of deposits (CDs), government money market accounts, and U.S. Treasury bills.锘 The 30-day U.S. Treasury bill is generally viewed as the baseline, risk-free security for financial modeling. It is backed by the full faith and credit of the U.S. government, and, given its relatively short maturity date, has minimal interest rate exposure.

Risk and Time Horizons

Time horizon and liquidity of investments is often a key factor influencing risk assessment and risk management. If an investor needs funds to be immediately accessible, they are less likely to invest in high risk investments or investments that cannot be immediately liquidated and more likely to place their money in riskless securities.

Time horizons will also be 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

Morningstar is one of the premier objective agencies that affixes risk ratings to mutual funds and聽exchange-traded funds聽(ETF).锘 An investor can match a portfolio鈥檚 risk profile with their own appetite for risk.

Types of Financial Risk

Every saving and investment action involves different risks and returns. In general, financial theory classifies investment risks affecting asset values into two categories: systematic risk聽and unsystematic risk. Broadly speaking, investors are exposed to both systematic and unsystematic risks.聽

Systematic risks, also known as market risks, are risks that can affect an entire economic market overall or a large percentage of the total market. Market risk聽is the risk of losing investments due to factors, such as聽political risk and macroeconomic risk, that affect the performance of the overall market. Market risk聽cannot be easily mitigated through portfolio diversification. Other common types of systematic risk can include interest rate risk, inflation risk, currency risk, liquidity risk, country risk, and sociopolitical risk.

Unsystematic risk, also known as specific risk or idiosyncratic risk, is a category of risk that only affects an industry or a particular company. Unsystematic risk is the risk of losing an investment due to company or industry-specific hazard. Examples include a change in management, a product recall, a regulatory change that could drive down company sales, and a new competitor in the marketplace with the potential to take away market share from a company. Investors often use diversification to manage unsystematic risk by investing in a variety of assets.

In addition to the broad systematic and unsystematic risks, there are several specific types of risk, including:

Business Risk

Business risk聽refers to the basic viability of a business鈥攖he 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. While financial risk is concerned with the costs of financing, business risk is concerned with all the other expenses a business must cover to remain operational and functioning. These expenses include salaries, production costs, facility rent, office, and administrative expenses. The level of a company's business risk is influenced by factors such as the cost of goods, profit margins, competition, and the overall level of demand for the products or services that it sells.

Credit or Default Risk

Credit risk聽is the risk that a borrower will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is particularly concerning to investors who hold bonds in their portfolios.聽Government bonds, especially those issued by the federal government, have the least amount of default risk and, as such, the lowest returns.聽Corporate bonds, on the other hand,聽tend to have the highest amount of default risk, but also higher interest rates. Bonds with a lower chance of default are considered聽investment grade, while bonds with higher chances are considered聽high yield or junk bonds. Investors can use聽bond rating agencies鈥攕uch as Standard and Poor鈥檚, Fitch and Moody's鈥攖o determine which bonds are investment-grade and which are junk.

Country Risk

Country risk聽refers to the risk that a country won't be able to honor its financial commitments. When a country聽defaults聽on its obligations, it can harm the performance of all other financial instruments in that country 鈥 as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options, and futures that are issued within a particular country. This type of risk is most often seen in聽emerging markets聽or countries that have a severe deficit.

Foreign-Exchange Risk

When investing in foreign countries, it鈥檚 important to consider the fact that currency exchange rates can change the price of the asset as well.聽Foreign exchange risk聽(or exchange rate risk) applies to all financial instruments that are in a currency other than your domestic currency. As an example, if you live in the U.S. and invest in a Canadian stock in Canadian dollars, even if the share value appreciates, you may lose money if the Canadian dollar depreciates in relation to the U.S. dollar.

Interest Rate Risk

Interest rate risk聽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, in the shape of the yield curve, or in any other interest rate relationship. This type of risk affects the value of bonds more directly than stocks and is a significant risk to all bondholders. As interest rates rise, bond prices in the secondary market fall鈥攁nd vice versa.

Political Risk

Political risk聽is the risk an investment鈥檚 returns could suffer because of political instability or changes in a country. This type of risk can stem from a change in government, legislative bodies, other foreign policy makers, or military control. Also known as geopolitical risk, the risk becomes more of a factor as an investment鈥檚 time horizon gets longer.

Counterparty Risk

Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions, especially for those occurring in over-the-counter (OTC) markets. Financial investment products such as stocks, options, bonds, and derivatives carry counterparty risk.

Liquidity Risk

Liquidity risk is associated with an investor鈥檚 ability to transact their investment for cash. Typically, investors will require some premium for illiquid assets which compensates them for holding securities over time that cannot be easily liquidated.

Risk vs. Reward

The聽risk-return tradeoff聽is the balance between the desire for the lowest possible risk and the highest possible returns. In general, low levels of risk are associated with low potential returns and high levels of risk are associated with high potential returns. Each investor must decide how much risk they鈥檙e willing and able to accept for a desired return. This will be based on factors such as age, income, investment goals, liquidity needs, time horizon, and personality.

The following chart shows a visual representation of the risk/return tradeoff for investing, where a higher standard deviation means a higher level or risk鈥攁s well as a higher potential return.聽聽

Image 1
Image by Sabrina Jiang 漏 Investopedia聽2020

It鈥檚 important to keep in mind that higher risk doesn鈥檛 automatically equate to higher returns. The risk-return tradeoff only indicates that higher risk investments have the possibility of higher returns鈥攂ut there are no guarantees. On the lower-risk side of the spectrum is the聽risk-free rate of return鈥攖he theoretical rate of return of an investment with zero risk. It represents the interest you would expect from an absolutely risk-free investment over a specific period of time. In theory, the risk-free rate of return is the minimum return you would expect for any investment because you wouldn鈥檛 accept additional risk unless the potential rate of return is greater than the risk-free rate.

Risk and Diversification

The most basic 鈥 and effective 鈥 strategy for minimizing risk is聽diversification. Diversification is based heavily on the concepts of correlation and risk. A well-diversified portfolio will consist of different types of securities from diverse industries that have varying degrees of risk and correlation with each other鈥檚 returns.

While most investment professionals agree that diversification can鈥檛 guarantee against a loss, it is the most important component to helping an investor reach long-range financial goals, while minimizing risk.

There are several ways to plan for and ensure adequate diversification including:聽

  1. Spread your portfolio among many different investment vehicles 鈥 including cash, stocks, bonds,聽mutual funds,聽ETFs聽and other funds. Look for assets whose returns haven鈥檛 historically moved in the same direction and to the same degree. That way, if part of your portfolio is declining, the rest may still be growing.
  2. Stay diversified within each type of investment. Include securities that vary by聽sector,聽industry, region, and聽market capitalization. It鈥檚 also a good idea to mix styles too, such as growth, income, and value. The same goes for bonds: consider varying maturities and credit qualities.
  3. Include securities that vary in risk. You're not restricted to picking only聽blue-chip stocks. In fact, the opposite is true. Picking different investments with different rates of return will ensure that large gains offset losses in other areas.

Keep in mind that portfolio diversification is not a one-time task. Investors and businesses perform regular 鈥渃heck-ups鈥 or rebalancing to make sure their portfolios have a risk level that鈥檚 consistent with their financial strategy and goals.

The Bottom Line

We all face risks every day鈥攚hether we鈥檙e driving to work, surfing a 60-foot wave, investing, or managing a business. In the financial world, risk refers to the chance that an investment鈥檚 actual return will differ from what is expected 鈥 the possibility that an investment won鈥檛 do as well as you鈥檇 like, or that you鈥檒l end up losing money.

The most effective way to manage investing risk is through regular risk assessment and diversification. Although diversification won鈥檛 ensure gains or guarantee against losses, it does provide the potential to improve returns based on your goals and target level of risk. Finding the right balance between risk and return helps investors and business managers achieve their financial goals through investments that they can be most comfortable with.