Whether it is political risk, currency risk, inflationary effects or economic risk, all need to have a risk assessment undertaken. Risk changes on a daily basis. You must be aware of all the influencing factors that may change your assessment of the risk element involved in any investment. As soon as the level of risk moves beyond that with which you are comfortable, you should divest your interests in that investment. There is always another investment with an acceptable level of risk waiting for you.
Risk assessment is essential to determine the risks that might affect you, as well as the investments you make. There are many risks that can affect an investment.
How do you define the word risk?
If you define risk in terms of loss then you are not seeing it in the right context for investing.
In investing you should be assessing risk as the deviation from an expected return.
What is the risk in the following example?
- You expect a return of 10%
- You obtain a return of 8%
Well the difference between the two is the risk element. I think you can do the math.
Investment professionals try to determine 'Total Risk'.
This is achieved by assessing all of the risk elements of 'unsystematic risk' with those of 'systematic risk'.
What Are Unsystematic Risk and Systemic Risk?
What is Unsystematic Risk?
It is the risk due to a unique factor affecting a single equity, such as a strike or a fire.
What is Systematic Risk?
It is the risk that affects all similar equities in a market - Market Risk.
Examples would be economic or political change.
Assessing Risk Assessment Assessments
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Component Elements Of Risk
Risk can be broken down further into component parts:
- Business Risk or Financial Risk
This is the risk that a particular company will fail due to poor management, lessening of market share, or perhaps a lowering in consumer demand.
- Purchasing Power Risk
The risk that inflation will have a negative impact on the buying power of capital, or income from interest.
- Interest Rate Risk
The risk that interest rates will rise and cause a fixed-income investment to decrease in value.
- Currency Risk
The risk that changes in the relative rate of exchange in currency, will have a negative impact when a foreign investment needs to be converted.
- Political Risk or Social Risk
Domestically, the risk that any political change may affect your investment adversely. Internationally, the risk that a major political upheaval may occur where you have your money invested, such as a revolution, earthquake or war.
Each has its unique effects on your investment.
But how do you decide what level of risk you are prepared to accept?
Acceptable Level Of Risk
When first starting in investing it is best to concentrate on those investments that have a low relative risk. These will give you a return on investment that is acceptable.
Remember, investing is about long-term gain against inflation. As long as you receive a total return that is greater than the current inflation rate you will be 'in profit'. If you start investing when young these small gains can build to substantial amounts, if you apply compounding.
Many investors believe they need to make substantial profits all of the time. This is not possible. Start slowly and build up your profits so that, once you are more confident about risk assessment, you can undertake more risky strategies. This does not mean high risk investment, just more risky than those that you start with.
A long-term investment strategy should begin with determining which investments can be liquidated quickly. Life throws those curve-balls, and you never know when you will require part of your investment portfolio for that rainy day. Having all your money in investments that tie that money in, is a risk in itself.
Risk assessment is all about assessing what might happen to you, as well as to the investments themselves.