Risk analysis of investment is one of the most complex, controversial and slippery areas in finance. Business decisions are generally made under conditions of uncertainty rather than under conditions approaching certainty. In fact, both risk and uncertainty are at the extreme ends of the same spectrum. The word “risk’ shall be used to connote the idea of the twofold possibility of loss or gain.
What is Risk?
Risk/ Financial 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.
Key Points:
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.
Some people things that investments are inclined to give emphasis on the possibility of loss but it is a negative pessimistic and depressing approach.
But some people things that investments are inclined to give emphasis to possibilities of gain which is optimistic.
In formal terms, the risk associated with a project o investment may be defined as the variability that is likely to occur in the future returns or investment.
Therefore, we relate risk to the variability of return i.e., the degree to which the return on investment varies unpredictably.
Parts of Risk
Shortly speaking risk is the variability of return from an investment. Returns on investment may vary from the expectation of the investors.
So risk may be defined as the likelihood that the actual return from an investment will be less than the expected return.
Depending upon the elements of risk, it may be broadly divided into two categories like systematic risk and unsystematic risk.
Some elements of risk that are external to the firm cannot be controlled and affect large numbers of securities are the sources of systematic risk.
On the other hand, controllable, internal factors somewhat peculiar to industries and/or firms are referred to as elements of unsystematic risk.
The risk associated with macro, pervasive factors such as a national economy is called systematic risk.
On the other hand, the micro risks associated with factors particular to a company are called unsystematic or unique risks. An investment manager can do little about systematic risk, although they can do much about unsystematic or unique risk.
Systematic risk
Systematic risk refers to that portion of the total variability in return on investment caused by factors affecting the prices of all securities in the portfolio.
Systematic risk is known as market risk. Economical, political, and sociological changes are the sources of systematic risk.
Their effect is to cause prices of nearly all individual assets like common stocks, bonds, and other securities in the market to move together in the same manner. Systematic risk affects the economic or financial system as a whole.
Systematic risk is also called pervasive risk may include several sourses.
Unsystematic risk
A portion of total risk that is unique or peculiar to a firm or an industry above and beyond that affecting the securities market, in general, may be termed as unsystematic risk. Management capability, consumer preference, and labor strikes are the elements of unsystematic risk.
However, the unsystematic risk of investment consists of two major components: credit risk and sector risk.
Categories of Risk
Systematic Risk
Market risk
Interest rate risk
Purchasing power risk
Exchange rate risk
Political
Liquidity risk
Default risk
Real estate risk
Unsystematic Risk
- Credit risk
- Business risk
- Financial risk
- Sector risk
The Bottom Line
We all face risks every day—whether we’re 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’s actual return will differ from what is expected—the possibility that an investment won’t do as well as you’d like, or that you’ll end up losing money.
The most effective way to manage investment risk is through regular risk assessment and diversification. Although diversification won’t ensure gains or guarantee against losses, it does provide the potential to improve returns based on your goals and target level of risk.
Related: 3 Types of Risk preference Investor
