Financial risk an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default.Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss.
There’s no such thing as a risk free investment; risk and return are always linked. When selecting investments you need to strike a balance between the risk you’re prepared to accept and the return you want. This is a very personal decision. A frequently quoted yardstick is the “sleep test” which recommends that you only put your money into investments that allow you to sleep at night.
When investing for short-term goals, those less than one year away, investments that provide less return, but also less risk, are appropriate. [...] Investing for medium-term goals, those from one to three years away, can be tricky because you need to balance risk and return. [...] When investing for longer-term goals, those more than three years away, you probably want to risk periodic volatility for longer-term gains.
Recently, some people have toyed with the idea of switching out of low-yielding bonds and into dividend-paying stocks to grab extra yield. The problem is that the potentially higher yield, or returns, inevitably comes with more risk -- even if the risk isn't readily apparent.
There are many types of risk. Business risk is the measure of risk associated with a particular security. It is also known as unsystematic risk and refers to the risk associated with a specific issuer of a security. [...] There is also market risk, which is the risk that market prices can fluctuate, sometimes called systematic risk. [...] Another risk, which many people don’t think about, is purchasing power risk. This is the risk that your investment will not keep up with inflation and you will not be able to maintain your desired standard of living.
A diversified portfolio of multiple types of investments that respond differently to changing economic factors can reduce risk and help you reach your financial goals.
The expected return on an asset can be divided into two parts: i) the return for deferring consumption, and ii) a compensation for bearing risk. The return for deferring compensation is, of course, simply rf, the return on the risk-free asset. Hence the return for bearing risk is E(ri) - rf. Mean-variance analysis implies that the return for bearing risk is proportional to the risk. Consequently, we can write the risk-return relationship as: E(ri) - rf = bi [E(rm) - rf],
Risk and reward go hand in hand; where there’s greater risk, there’s greater potential return as well. Funds ranking high on a risk-adjusted return scale demonstrate a favorable tradeoff between risk and reward. That is, either the returns were high enough to compensate for the additional risk taken, or the returns were not high relative to other investments but the risk taken was much lower.
In standard asset pricing theory, expected stock returns are related cross-sectionally to returns' sensitivities to state variables with pervasive effects on investors' overall welfare. A security whose lowest returns tend to accompany unfavorable shifts in that welfare must offer additional compensation to investors for holding the security. Liquidity appears to be a good candidate for a priced state variable. It is often viewed as an important feature of the investment environment and macroeconomy, and recent studies find that fluctuations in various measures of liquidity are correlated across assets.
The original theory of stock options valuation and its manifold extensions has been so widely embraced because it provides an unequivocal and almost sentiment-free prescription for the replacement of an apparently risky, unpriced asset by a mixture of other assets with known prices. But this elegant case is the exception. Most risky assets cannot be replicated, even in theory.
Most of the literature dealing with risky choice behavior assumes that decision makers are risk averse. That assumption is a basic premise of much research in business, finance, economics, and management science. [...] Current evidence [...] reveals that most individuals exhibit a mixture of risk-seeking and risk-averse behavior, with the range of the returns where those two risk preferences are the predominant modes of behavior being intimately connected with the notion of a target return.
Rate of return and Risk in return represent the dimensions of expectation and uncertainty. The tradeoffs between them are real and faced by individuals and businesses frequently. The decision to invest involves a choice among alternatives having both varying anticipated return and risk. Being averse to risk, individuals and businesses choose the least risky investment for a given level of anticipated return, or require a greater return when investments are riskier. The investor perspective with respect to risk tends to be one of concern with the degree to which returns might depart (or vary) from the expected level.
The single most important contemporary issue in finance is the equity risk premium. This drives future equity returns, and is the key determinant of the cost of capital. The risk premium – the expected reward for bearing the risk of investing in equities, rather than in low- risk investments such as bills or bonds – is usually estimated from historical data.