What Is Risk? Detailed Explanation With Example

In finance, risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision. Risk is also defined as the volatility of returns

What Is Risk?

In finance, risk is the probability that actual results will differ from expected results. Risk includes the possibility of losing some or all of an original investment.

The concept of “risk and return” says that riskier assets should have higher expected returns to compensate investors for higher volatility and risk. In finance, standard deviation is a commonly used risk metric. Standard deviation measures the volatility of asset prices compared to their historical averages over a given time period.

In the Capital Asset Pricing Model (CAPM) also risk is defined as the volatility of returns.

Understanding Risk

Every investment carries certain a degree of risk and that is the basis of risk-return tradeoff. The greater the amount of risk an investor is willing to take, the greater the potential return. Risks can come in various ways and investors need to be compensated for taking on additional risk.

For example, a bond is considered to be safe because it guarantees fixed annual payments and thus carries less risk. On the other hand, a stock carries a high level of risk because payments are not guaranteed, but it may also result in higher returns.

Measuring and calculating risk often enables investors, traders, and business managers to reduce some risks through a variety of strategies such as diversification and derivative positions.

Types of Risk

In general, financial theory divides investment risks affecting asset values into two types: systematic and unsystematic risk. Generally speaking, investors face both systematic and unsystematic risks.

Sytematic Risk

Systematic risk, also known as market risk, is the inherent risk that affects the entire market or a large segment of it due to factors beyond an individual company’s control.

Systematic risk stems from macroeconomic factors such as inflation, interest rate changes, geopolitical events, recessions, or natural disasters. It cannot be eliminated through diversification because it impacts all assets to varying degrees.

Key types of systematic risk include:

Market Risk: Risk of overall market volatility impacting asset prices.
Interest Rate Risk: Risk from changes in borrowing costs affecting investments.
Inflation Risk: Risk of reduced purchasing power eroding investment returns.
Exchange Rate Risk: Risk of currency fluctuations affecting foreign investments.
Political/Government Risk: Risk from policy changes or geopolitical instability disrupting markets.

Systematic risk is measured by beta and by ratios (Treynor Ratio and Jensen Alpha)

Unsystematic Risk

Unsystematic risk, also known as specific or idiosyncratic risk, refers to risks unique to a particular company, industry, or asset. Unlike systematic risk, it can be reduced or eliminated through diversification in a well-balanced portfolio.

This type of risk arises from internal or controllable factors affecting individual entities rather than the broader market.

Key types of unsystematic risk include:

Business Risk: Risk of a company’s operations or management impacting profitability.
Financial Risk: Risk from a company’s use of excessive debt or poor financial structure.
Industry Risk: Risk from adverse conditions specific to an industry or sector.
Operational Risk: Risk from internal failures, such as technical issues or fraud.
Event Risk: Risk of unexpected events like lawsuits, strikes, or natural disasters affecting a company.

Unystematic risk is measured by ratios (Sharpe Ratio and M^2)

Riskless Securities

While no investment is completely risk-free, some securities carry so little practical risk that they are considered risk-free or riskless.

A risk-free asset, like a government bond, serves as the baseline to measure risk because it offers guaranteed returns. Other investments are compared against it, with the additional returns (risk premium) compensating for taking on higher risk.

An example of a risk-free asset is a U.S. Treasury Bill (T-Bill), as it is backed by the U.S. government and has virtually no default risk. The 30-day U.S. Treasury bill is generally viewed as the baseline, risk-free security for financial modeling

Important While U.S. government bonds often get referred to as "riskless," investors may lose money if the government defaults on its debt. This is why we add a default spread to government rates.

Risk vs. Reward

The risk-return tradeoff highlights the principle that higher potential returns come with higher risks. Investors must balance their risk tolerance with desired returns, as safer investments (e.g., bonds) offer lower returns, while riskier assets (e.g., stocks) provide greater potential rewards but with increased uncertainty and potential for loss.

The following chart shows a visual representation of the risk-return tradeoff for investing, where a higher standard deviation means a higher level or risk—as well as a higher potential return.

Key Takeaways

We face risks every day—whether it’s crossing the road, climbing a mountain, starting a business, or investing money. In finance, risk means the possibility that an investment’s return might not meet expectations or could result in a loss.

The best way to manage investment risk is by regularly evaluating it and spreading your investments across different assets. While diversification can’t guarantee profits or prevent losses, it can help improve returns depending on your goals and risk tolerance. Striking the right balance between risk and reward allows investors and managers to reach their financial goals in a way that feels comfortable.

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