The most important term in the financial world to know and understand is risk management. The most basic definition of risk management is identifying, analyzing, and accepting or mitigation the uncertainty of an investment decision.
Risk management will typically be used when an investor or fund manager must analyze and quantify any potential for losses in an investment. This will help them to determine the appropriate action, or possibly inaction, for the investment’s objectives and how much risk could be allowed to be taken on.
A Larger Definition
An investor uses risk management for a wide variety of reasons and instances. From checking an individual’s credit to buying low-risk government bonds over riskier corporate bonds, there is always a risk that must be analyzed and accounted for. How the risk is analyzed can differ between different strategies. Stockbrokers, for instance, will use financial instruments like options and futures. Money managers tend to use strategies such as portfolio and investment diversification for risk management. If the risk isn’t assessed or analyzed properly, it could be catastrophic for the investor.
The risks to be wary of in the financial world is anything that will deviate from the investor’s expected outcome. While there will always be uncertainty with any investment, it’s imperative for an investor to evaluate their risk tolerance.
Measuring the Risk
There are certain ways that risk is measured in the financial world. There are many different tactics for an investor to use. A tactic that is commonly used is a standard deviation. Standard deviation is a statistical measure of dispersion around a central tendency. Investors assess the average return and its average standard deviation over the same time period. This process will help them determine a numerical risk and whether or not they’re able to tolerate the risk.
The two most deciding factors in risk management are market and systematic risk. Although these will give investors the greater idea of the risk an investment will pose, there are other factors that can influence risk. To account for other influencing factors, investors should follow an active strategy. Active strategies factor in sector or country, stock, charting, and fundamental analysis. This allows the risk management to weigh all of the factors that may affect an investment and evaluate if the risk tolerance can handle it.