Financial Risk: Its Definition and Types

October 17, 20225 min read
Financial Risk: Its Definition and Types
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Key Takeaways

• Financial risk is the possibility of losing some or all of an investment.

• Risk has several different varieties for both investors and businesses.

• Risk analysis, diversification and hedging are key mitigation strategies.

In the simplest terms, risk is defined in finance as the possibility of an outcome differing from the anticipated result. It could mean losing a portion — or the entirety — of an investment. Analysts try to measure the riskiness of an investment using metrics such as standard deviation to gauge the potential volatility of the price of an asset. 

These efforts to understand risks as they apply to specific situations can help investors minimize, though not completely eliminate, the potential for losses. Generally, the potential for risk is evaluated based upon past outcomes for similar ventures. Understanding risk and how it is measured is key to the potential success of any investment activity.

The Fundamentals of Risk

Every aspect of life entails some sort of risk. Nothing is absolutely guaranteed to turn out as expected. With this in mind, smart people do what they can to manage inherent perils in an effort to minimize the consequences should they occur. 

When it comes to investing, the fundamental concept to grasp is the idea of risk vs reward. Because every action entails a degree of risk, it is important to consider the nature of the reward the risk could bring. Ideally, the greater the accepted risk, the more significant the potential reward. Or, said differently, the more risk an investor takes on, the higher the expected return should be.

Before investing, it is prudent for individuals to consider their personalities, lifestyles and ages, as these factors will help determine their ability, as well as their willingness, to tolerate risk. For example, a younger person just starting their career path and investing to secure their future retirement is in a good position to take greater risks. After all, they have more time with which to recover from bad breaks. Conversely, an investor with the same goal, but only a few years away from retirement, would be wise to be less aggressive with their investment strategies.

Risk and Businesses 

Businesses live and die by cash flow — the money coming in from sales and the money going out to defray expenses. Any circumstance with the potential to interrupt cash flow poses a threat to a business. These risks include non-paying clients, unfavorable changes in market conditions, faulty management and crippling technical failures. 

Businesses face five primary types of risk, these include:

Market risk can occur when the atmosphere in which a company operates changes. A good example of this is the way online shopping caused the retail paradigm to shift.

Credit risk can result from offering credit to customers who fail to pay.

Liquidity risk refers to an inability to come up with cash to satisfy a sudden need, or being unable to pay bills.

Operational risk can result from poor management decisions, fraudulent activity, unresolvable technical issues, or the failure of a business model.

Currency risk occurs in instances in which exchange rates move against the company’s dominant currency. This applies primarily to businesses that are heavily reliant upon import and export of goods.

Risk and Individuals

In the broadest terms, investors must contend with two types of risk: systematic and unsystematic. Systematic risks are also referred to as market risks because they can be experienced by the whole market. These include interest rate risk, inflation risk, currency risk, liquidity risk, country risk, and sociopolitical risk. Portfolio diversification, one of the primary risk mitigation tools for investors, does little to mitigate these threats.

Unsystematic risk affects a specific industry, or company, while leaving the rest of the market unscathed. An investment in a poorly managed company, or a company whose signature product experiences a recall, are examples of unsystematic risk. Other factors contributing to this type of risk include regulatory issues, or losing market share to a new competitor. Investments in companies subjected to issues of this nature are likely to be jeopardized. 

Individuals can face four major types of risk, including:

Liquidity risk – when assets cannot be acquired or offloaded to mitigate losses in a volatile market.

Speculative risk – occurs when investors fail to conduct due diligence, overreach, or overinvest in a single asset.

Currency risk can result from interest rate changes and monetary policy changes. Volatile foreign investment conditions can also expose individuals to currency risk.  

Tools for Controlling Financial Risk

Among the tools employed for the purpose of analyzing financial risk for investors are:

Fundamental analysiswhich evaluates critical aspects of a firm’s underpinnings, such as its assets and earnings.

Technical analysis – a review of historical returns, trade volumes, share prices and other tangible performance metrics.

Quantitative analysis – applying defined financial ratio calculations to the historical performance of an equity.

Hedging is another commonly employed tactic by investors to help mitigate potential risk. Such techniques employed to mitigate potential decreases in the value of investments are commonly referred to as downside protection. Approaches include stop-loss orders, trailing stops and options contracts. Portfolio diversification can also be a useful tool for managing risk. 

Portfolio Diversification and Alternative Investments 

Varying the mix of asset classes held within a portfolio can help mitigate risk for investors. In many cases, fixed-price assets such as bonds, certificates of deposit and treasury notes can respond to market volatility more favorably than publicly traded equities.

Alternative investments can also be useful tools for portfolio diversification, which is generally agreed upon by experts to be a smart investment strategy to pursue. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, and collectibles are among asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. 

These asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  Yieldstreet opens several investment strategies that were formerly available only to institutional investors and the top one percent of earners to all investors. 

The company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Investing and risk go hand in hand. The key is to ensure that the potential reward is worth the risk one must accept in exchange.  Understanding, measuring and taking steps to minimize risk are of the utmost importance to investors and businesses alike.