Understanding Financial Risk - Part 1
This blog is the first in a three-part series explaining Financial Risk. In our first article, we will discuss what risk is and how the risk/reward relationship is relevant to your financial situation. Stay tuned for our next two articles to learn more about financial risk.
WHAT IS RISK?
We commonly think about risk as an uncertainty with the chance of a negative impact or outcome. The Oxford Dictionary defines risk as ‘exposure to the possibility of loss, injury or other adverse circumstance’. (2007)
In investing, we talk about the volatility of an investment as being how much the price of that investment changes over time, whereas investment risk refers to a negative movement in that price.
When thinking about your financial well-being, the most common risks to consider are:
Investment (or market) risk: the uncertainty about the expected rate of return on an investment or of an investment;
Default risk: the risk that an organisation is unable to pay their debts or financial obligations as they fall due;
Market timing risk: the risk of buying or selling investments at the wrong time;
Currency risk: the risk of incorrectly predicting the direction of currency movements; and
Liquidity risk: the risk that you will not be able to sell your investment when you would like to, or without a significant change in price.
There are also risks that affect you directly that should be considered in the preparation and ongoing execution of your financial plan. Such risks include:
Significant illness or injury, such as heart attack, stroke or cancer,
Loss of your job, or a marked reduction in working hours;
Business failure, adversity or litigation;
Separation, divorce or other family difficulties; and
External factors, including legislative change.
THE RISK/REWARD RELATIONSHIP
Generally speaking, risk and reward are related. If you’re prepared to accept higher risks, then over time you could expect to earn a higher return or payoff. Compare a business entrepreneur with someone prepared to work for a known salary or wage – the risks of the former are higher, as are the potential returns.
In financial terms, there is also a relationship between the two. The long-term return on higher risk investments, such as shares and property, is higher than cash, yet the short-term prices of shares and property can vary widely.
Risk and return are usually related
There have been cases of businesses offering investors lower returns on their investments in an effort to falsely increase the perceived security of the investment. For example, high risk mezzanine property finance should offer a return of between 15 and 17 percent. Knowing that many investors would see such high returns as indicative of high risk, the manager instead offers a return of 8 percent. The risk is still present, however some investors may wrongfully believe an eight percent return indicates a lower level of risk.
To talk to someone about your investment portfolio, and if it is a suitable level of risk for your current situation and your financial goals;
