Risk Definition - Investopedia

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 ... TradingSkills&Essentials RiskManagement TradingSkills&Essentials UltimateTradingGuide:Options,Futures,andTechnicalAnalysis DayTradingIntroduction TradingBasicEducation TradingPlatforms&Tools TradingOrderTypes&Processes TradingInstruments RiskManagement MoneyManagement TradingPsychology TradingLifestyle SeeAll TableofContents Expand WhatIsRisk? TheBasicsofRisk RisklessSecurities RiskandTimeHorizons MorningstarRiskRatings TypesofFinancialRisk Riskvs.Reward RiskandDiversification TheBottomLine WhatIsRisk? Riskisdefinedinfinancialtermsasthechancethatanoutcomeorinvestment'sactualgainswilldifferfromanexpectedoutcomeorreturn.Riskincludesthepossibilityoflosingsomeorallofanoriginalinvestment. Quantifiably,riskisusuallyassessedbyconsideringhistoricalbehaviorsandoutcomes.Infinance,standarddeviationisacommonmetricassociatedwithrisk.Standarddeviation providesameasureofthevolatilityofassetpricesincomparisontotheirhistoricalaveragesinagiventimeframe. Overall,itis possibleandprudenttomanageinvestingrisksbyunderstandingthebasicsofriskandhowitismeasured.Learningtherisksthatcanapplytodifferentscenariosandsomeofthewaystomanagethemholisticallywillhelpalltypesofinvestorsandbusinessmanagerstoavoidunnecessaryandcostlylosses. 1:17 UnderstandingRiskAndTimeHorizon TheBasicsofRisk Everyoneisexposedtosometypeofriskeveryday–whetherit’sfromdriving,walkingdownthestreet,investing,capitalplanning,orsomethingelse.Aninvestor’spersonality,lifestyle,andagearesomeofthetopfactorstoconsiderforindividualinvestmentmanagementandriskpurposes.Eachinvestorhasaunique riskprofile thatdeterminestheirwillingnessandabilitytowithstandrisk.Ingeneral,asinvestmentrisksrise,investorsexpecthigherreturnstocompensatefortakingthoserisks. Afundamentalideainfinanceistherelationshipbetweenriskandreturn.Thegreatertheamountofriskaninvestoriswillingtotake,thegreaterthepotentialreturn.Riskscancomeinvariouswaysandinvestorsneedtobecompensatedfortakingonadditionalrisk.Forexample,aU.S. Treasurybond isconsideredoneofthesafestinvestmentsandwhencomparedtoa corporatebond,providesalowerrateofreturn.AcorporationismuchmorelikelytogobankruptthantheU.S.government.Becausethedefaultriskofinvestinginacorporatebondishigher,investorsareofferedahigherrateofreturn. Quantifiably,riskisusuallyassessedbyconsideringhistoricalbehaviorsandoutcomes.Infinance,standarddeviationisacommonmetricassociatedwithrisk.Standarddeviation providesameasureofthevolatilityofavalueincomparisontoitshistoricalaverage.Ahighstandarddeviationindicatesalotofvaluevolatilityandthereforeahighdegreeofrisk. Individuals,financialadvisors,andcompaniescanalldevelopriskmanagement strategiestohelpmanagerisksassociatedwiththeirinvestmentsandbusinessactivities.Academically,thereareseveraltheories,metrics,andstrategiesthathavebeenidentifiedtomeasure,analyze,andmanagerisks.Someoftheseinclude:standarddeviation,beta,ValueatRisk(VaR),andtheCapitalAssetPricingModel(CAPM).Measuringandquantifyingriskoftenallowsinvestors,traders,andbusinessmanagerstohedgesomerisksawaybyusingvariousstrategiesincludingdiversificationandderivativepositions. KeyTakeaways Risktakesonmanyformsbutisbroadlycategorizedasthechanceanoutcomeorinvestment'sactualgainwilldifferfromtheexpectedoutcomeorreturn.Riskincludesthepossibilityoflosingsomeorallofaninvestment.Thereareseveraltypesofriskandseveralwaystoquantifyriskforanalyticalassessments.Riskcanbereducedusingdiversificationandhedgingstrategies. RisklessSecurities Whileitistruethatnoinvestmentisfullyfreeofallpossiblerisks,certainsecuritieshavesolittlepracticalriskthattheyareconsideredrisk-freeorriskless. Risklesssecuritiesoftenformabaselineforanalyzingandmeasuringrisk.Thesetypesofinvestmentsofferanexpectedrateofreturnwithverylittleornorisk.Oftentimes,alltypesofinvestorswilllooktothesesecuritiesforpreservingemergencysavingsorforholdingassetsthatneedtobeimmediatelyaccessible. Examplesofrisklessinvestmentsandsecuritiesincludecertificatesofdeposits(CDs),governmentmoneymarketaccounts,andU.S.Treasurybills.The30-dayU.S.Treasurybillisgenerallyviewedasthebaseline,risk-freesecurityforfinancialmodeling.ItisbackedbythefullfaithandcreditoftheU.S.government,and,givenitsrelativelyshortmaturitydate,hasminimalinterestrateexposure. RiskandTimeHorizons Timehorizonandliquidityofinvestmentsisoftenakeyfactorinfluencingriskassessmentandriskmanagement.Ifaninvestorneedsfundstobeimmediatelyaccessible,theyarelesslikelytoinvestinhighriskinvestmentsorinvestmentsthatcannotbeimmediatelyliquidatedandmorelikelytoplacetheirmoneyinrisklesssecurities. Timehorizonswillalsobeanimportantfactorforindividualinvestmentportfolios.Youngerinvestorswithlongertimehorizonstoretirementmaybewillingtoinvestinhigherriskinvestmentswithhigherpotentialreturns.Olderinvestorswouldhaveadifferentrisktolerancesincetheywillneedfundstobemorereadilyavailable. MorningstarRiskRatings Morningstarisoneofthepremierobjectiveagenciesthataffixesriskratingstomutualfundsand exchange-tradedfunds (ETF).Aninvestorcanmatchaportfolio’sriskprofilewiththeirownappetiteforrisk. TypesofFinancialRisk Everysavingandinvestmentactioninvolvesdifferentrisksandreturns.Ingeneral,financialtheoryclassifiesinvestmentrisksaffectingassetvaluesintotwocategories:systematicrisk andunsystematicrisk.Broadlyspeaking,investorsareexposedtobothsystematicandunsystematicrisks.  Systematicrisks,alsoknownasmarketrisks,arerisksthatcanaffectanentireeconomicmarketoveralloralargepercentageofthetotalmarket.Marketrisk istheriskoflosinginvestmentsduetofactors,suchas politicalriskandmacroeconomicrisk,thataffecttheperformanceoftheoverallmarket.Marketrisk cannotbeeasilymitigatedthroughportfoliodiversification.Othercommontypesofsystematicriskcanincludeinterestraterisk,inflationrisk,currencyrisk,liquidityrisk,countryrisk,andsociopoliticalrisk. Unsystematicrisk,alsoknownasspecificriskoridiosyncraticrisk,isacategoryofriskthatonlyaffectsanindustryoraparticularcompany.Unsystematicriskistheriskoflosinganinvestmentduetocompanyorindustry-specifichazard.Examplesincludeachangeinmanagement,aproductrecall,aregulatorychangethatcoulddrivedowncompanysales,andanewcompetitorinthemarketplacewiththepotentialtotakeawaymarketsharefromacompany.Investorsoftenusediversificationtomanageunsystematicriskbyinvestinginavarietyofassets. Inadditiontothebroadsystematicandunsystematicrisks,thereareseveralspecifictypesofrisk,including: BusinessRisk Businessrisk referstothebasicviabilityofabusiness—thequestionofwhetheracompanywillbeabletomakesufficientsalesandgeneratesufficientrevenuestocoveritsoperationalexpensesandturnaprofit.Whilefinancialriskisconcernedwiththecostsoffinancing,businessriskisconcernedwithalltheotherexpensesabusinessmustcovertoremainoperationalandfunctioning.Theseexpensesincludesalaries,productioncosts,facilityrent,office,andadministrativeexpenses.Thelevelofacompany'sbusinessriskisinfluencedbyfactorssuchasthecostofgoods,profitmargins,competition,andtheoveralllevelofdemandfortheproductsorservicesthatitsells. CreditorDefaultRisk Creditrisk istheriskthataborrowerwillbeunabletopaythecontractualinterestorprincipalonitsdebtobligations.Thistypeofriskisparticularlyconcerningtoinvestorswhoholdbondsintheirportfolios. Governmentbonds,especiallythoseissuedbythefederalgovernment,havetheleastamountofdefaultriskand,assuch,thelowestreturns. Corporatebonds,ontheotherhand, tendtohavethehighestamountofdefaultrisk,butalsohigherinterestrates.Bondswithalowerchanceofdefaultareconsidered investmentgrade,whilebondswithhigherchancesareconsidered highyieldorjunkbonds.Investorscanuse bondratingagencies—suchasStandardandPoor’s,FitchandMoody's—todeterminewhichbondsareinvestment-gradeandwhicharejunk. CountryRisk Countryrisk referstotheriskthatacountrywon'tbeabletohonoritsfinancialcommitments.Whenacountry defaults onitsobligations,itcanharmtheperformanceofallotherfinancialinstrumentsinthatcountry–aswellasothercountriesithasrelationswith.Countryriskappliestostocks,bonds,mutualfunds,options,andfuturesthatareissuedwithinaparticularcountry.Thistypeofriskismostoftenseenin emergingmarkets orcountriesthathaveaseveredeficit. Foreign-ExchangeRisk Wheninvestinginforeigncountries,it’simportanttoconsiderthefactthatcurrencyexchangeratescanchangethepriceoftheassetaswell. Foreignexchangerisk (orexchangeraterisk)appliestoallfinancialinstrumentsthatareinacurrencyotherthanyourdomesticcurrency.Asanexample,ifyouliveintheU.S.andinvestinaCanadianstockinCanadiandollars,evenifthesharevalueappreciates,youmaylosemoneyiftheCanadiandollardepreciatesinrelationtotheU.S.dollar. InterestRateRisk Interestraterisk istheriskthataninvestment'svaluewillchangeduetoachangeintheabsolutelevelofinterestrates,thespreadbetweentworates,intheshapeoftheyieldcurve,orinanyotherinterestraterelationship.Thistypeofriskaffectsthevalueofbondsmoredirectlythanstocksandisasignificantrisktoallbondholders.Asinterestratesrise,bondpricesinthesecondarymarketfall—andviceversa. PoliticalRisk Politicalrisk istheriskaninvestment’sreturnscouldsufferbecauseofpoliticalinstabilityorchangesinacountry.Thistypeofriskcanstemfromachangeingovernment,legislativebodies,otherforeignpolicymakers,ormilitarycontrol.Alsoknownasgeopoliticalrisk,theriskbecomesmoreofafactorasaninvestment’stimehorizongetslonger. CounterpartyRisk Counterpartyriskisthelikelihoodorprobabilitythatoneofthoseinvolvedinatransactionmightdefaultonitscontractualobligation.Counterpartyriskcanexistincredit,investment,andtradingtransactions,especiallyforthoseoccurringinover-the-counter(OTC)markets.Financialinvestmentproductssuchasstocks,options,bonds,andderivativescarrycounterpartyrisk. LiquidityRisk Liquidityriskisassociatedwithaninvestor’sabilitytotransacttheirinvestmentforcash.Typically,investorswillrequiresomepremiumforilliquidassetswhichcompensatesthemforholdingsecuritiesovertimethatcannotbeeasilyliquidated. Riskvs.Reward The risk-returntradeoff isthebalancebetweenthedesireforthelowestpossibleriskandthehighestpossiblereturns.Ingeneral,lowlevelsofriskareassociatedwithlowpotentialreturnsandhighlevelsofriskareassociatedwithhighpotentialreturns.Eachinvestormustdecidehowmuchriskthey’rewillingandabletoacceptforadesiredreturn.Thiswillbebasedonfactorssuchasage,income,investmentgoals,liquidityneeds,timehorizon,andpersonality. Thefollowingchartshowsavisualrepresentationoftherisk/returntradeoffforinvesting,whereahigherstandarddeviationmeansahigherlevelorrisk—aswellasahigherpotentialreturn.   ImagebySabrinaJiang©Investopedia 2020 It’simportanttokeepinmindthathigherriskdoesn’tautomaticallyequatetohigherreturns.Therisk-returntradeoffonlyindicatesthathigherriskinvestmentshavethepossibilityofhigherreturns—buttherearenoguarantees.Onthelower-risksideofthespectrumisthe risk-freerateofreturn—thetheoreticalrateofreturnofaninvestmentwithzerorisk.Itrepresentstheinterestyouwouldexpectfromanabsolutelyrisk-freeinvestmentoveraspecificperiodoftime.Intheory,therisk-freerateofreturnistheminimumreturnyouwouldexpectforanyinvestmentbecauseyouwouldn’tacceptadditionalriskunlessthepotentialrateofreturnisgreaterthantherisk-freerate. RiskandDiversification Themostbasic–andeffective–strategyforminimizingriskis diversification.Diversificationisbasedheavilyontheconceptsofcorrelationandrisk.Awell-diversifiedportfoliowillconsistofdifferenttypesofsecuritiesfromdiverseindustriesthathavevaryingdegreesofriskandcorrelationwitheachother’sreturns. Whilemostinvestmentprofessionalsagreethatdiversificationcan’tguaranteeagainstaloss,itisthemostimportantcomponenttohelpinganinvestorreachlong-rangefinancialgoals,whileminimizingrisk. Thereareseveralwaystoplanforandensureadequatediversificationincluding:  Spreadyourportfolioamongmanydifferentinvestmentvehicles–includingcash,stocks,bonds, mutualfunds, ETFs andotherfunds.Lookforassetswhosereturnshaven’thistoricallymovedinthesamedirectionandtothesamedegree.Thatway,ifpartofyourportfolioisdeclining,therestmaystillbegrowing. Staydiversifiedwithineachtypeofinvestment.Includesecuritiesthatvaryby sector, industry,region,and marketcapitalization.It’salsoagoodideatomixstylestoo,suchasgrowth,income,andvalue.Thesamegoesforbonds:considervaryingmaturitiesandcreditqualities. Includesecuritiesthatvaryinrisk.You'renotrestrictedtopickingonly blue-chipstocks.Infact,theoppositeistrue.Pickingdifferentinvestmentswithdifferentratesofreturnwillensurethatlargegainsoffsetlossesinotherareas. Keepinmindthatportfoliodiversificationisnotaone-timetask.Investorsandbusinessesperformregular“check-ups”orrebalancingtomakesuretheirportfolioshavearisklevelthat’sconsistentwiththeirfinancialstrategyandgoals. TheBottomLine Weallfaceriskseveryday—whetherwe’redrivingtowork,surfinga60-footwave,investing,ormanagingabusiness.Inthefinancialworld,riskreferstothechancethataninvestment’sactualreturnwilldifferfromwhatisexpected–thepossibilitythataninvestmentwon’tdoaswellasyou’dlike,orthatyou’llenduplosingmoney. Themosteffectivewaytomanageinvestingriskisthroughregularriskassessmentanddiversification.Althoughdiversificationwon’tensuregainsorguaranteeagainstlosses,itdoesprovidethepotentialtoimprovereturnsbasedonyourgoalsandtargetlevelofrisk.Findingtherightbalancebetweenriskandreturnhelpsinvestorsandbusinessmanagersachievetheirfinancialgoalsthroughinvestmentsthattheycanbemostcomfortablewith. ArticleSources Investopediarequireswriterstouseprimarysourcestosupporttheirwork.Theseincludewhitepapers,governmentdata,originalreporting,andinterviewswithindustryexperts.Wealsoreferenceoriginalresearchfromotherreputablepublisherswhereappropriate.Youcanlearnmoreaboutthestandardswefollowinproducingaccurate,unbiasedcontentinour editorialpolicy. U.S.SecuritiesandExchangeCommission."AssessingYourRiskTolerance."AccessedJuly27,2020. FederalReserveBankofSanFrancisco."InTimesofFinancialStress,WhatTypicallyHappenstotheDifferencebetweenInterestRatesonCorporateBondsandU.S.TreasuryBonds?"AccessedJuly27,2020. U.S.SecuritiesandExchangeCommission."WhatIsRisk?"AccessedJuly27,2020. U.S.SecuritiesandExchangeCommission."TreasurySecurities."AccessedJuly27,2020. U.S.DepartmentoftheTreasury."TreasurySecuritiesandPrograms."AccessedJuly27,2020. U.S.SecuritiesandExchangeCommission."AssetAllocation."AccessedJuly27,2020. Morningstar."RatingsandRisk."AccessedJuly27,2020. U.S.SecuritiesandExchangeCommission."DiversifyYourInvestments."AccessedJuly27,2020. CompareAccounts AdvertiserDisclosure × TheoffersthatappearinthistablearefrompartnershipsfromwhichInvestopediareceivescompensation.Thiscompensationmayimpacthowandwherelistingsappear.Investopediadoesnotincludealloffersavailableinthemarketplace. Provider Name Description RelatedTerms ExcessReturnsDefinition Excessreturnsarereturnsachievedaboveandbeyondthereturnofaproxy.Excessreturnswilldependonadesignatedinvestmentreturncomparisonforanalysis. more WhatIsExpectedReturn? Theexpectedreturnistheamountofprofitorlossaninvestorcananticipatereceivingonaninvestmentovertime. more EfficientFrontierDefinition Theefficientfrontiercomprisesinvestmentportfoliosthatofferthehighestexpectedreturnforaspecificlevelofrisk. more WhatIstheS&P600? TheS&P600isanindexofsmall-capstocksmanagedbyStandardandPoor's,comparabletotheRussell2000. more SharpeRatioDefinition TheSharperatioisusedtohelpinvestorsunderstandthereturnofaninvestmentcomparedtoitsrisk. more WhatIsaRiskPremium? Ariskpremiumisthereturninexcessoftherisk-freerateofreturnthataninvestmentisexpectedtoyield. more PartnerLinks RelatedArticles ForexTradingStrategy&Education Top5ForexRisksTradersShouldConsider CorporateBonds 6BiggestBondRisks PortfolioConstruction ModernPortfolioTheory:WhyIt'sStillHip RiskManagement HowInvestmentRiskIsQuantified RiskManagement Whataresomeexamplesofrisksassociatedwithfinancialmarkets? Debt FinancialRiskvs.BusinessRisk:UnderstandingtheDifference