- Types of Financial Risk
- Risk and Diversification
Risk is the possibility of loss, or the possibility of something negative happening. It refers to the chance that an undesirable event may occur, leading to negative consequences. It can result in unfavourable consequences such as financial loss, injury, or damage. It involves taking into consideration the probability and the possible impact of the event.
Types of Financial Risk
- Market Risk: This risk is the risk of losses arising from movements in market variables like prices and volatility. It occurs due to the movement in prices of financial instruments. This risk cannot be eliminated through diversification because it affects all investments within a particular market. We can also call it systematic risk.
- Liquidity Risk: The risk of not being able to buy and sell assets quickly without significantly affecting their prices. It can also refer to difficulty in accessing cash when needed. The inability to execute transactions results in this type of risk.
- Credit Risk: This risk arises when a borrower or issuer of debt instruments fails to meet their financial obligations by not repaying borrowed money or interest on time. It is also known as default risk. The risk that a borrower or issuer of debt may fail to make principal or interest payments as agreed or the risk that a counterparty in a financial transaction may not meet its obligations are all types of credit risk.
- Operational Risk: Risk arising out of operational failures such as mismanagement or technical failures are called operational risks. These risks are associated with inadequate or failed internal processes, systems, human error, or external events that can lead to financial losses. The operational risk stems from the internal workings of an organisation and various non-financial factors.
Risk and Diversification
Diversification is one of the key strategies in managing financial risk. To reduce the impact of a negative event in any one area, investments are spread across various assets, industries, or markets. Even though diversification can significantly lower the overall risk exposure in your portfolio it doesn’t eliminate it. That means the risk factor still exists even after diversification.
Here's how diversification can help mitigate different types of financial risks:
- Market Risk: Diversifying investments across several properties efficiently reduces the threat associated with fluctuations in the market. For instance, having a various portfolio that includes stocks, bonds, and actual property lets in for a nicely-rounded funding strategy. This means that even if one marketplace experiences a downturn, the overall profits and losses are balanced, leading to more stability in the end.
- Liquidity Risk: By accurately allocating your investments across special sorts of belongings, you can mitigate the capability chance of no longer being capable of accessing your finances while wished. By having a large portfolio of stocks, bonds, and cash equivalents, you grow the chance of getting without difficulty available coins within the occasion of an unexpected situation.
- Credit Risk: Diversification reduces your credit risk by not putting all your funds into a single issuer or borrower. Default by one issuer on their debt, won’t impact your overall portfolio, the impact is minimised. Holding bonds from various issuers or investing in diversified mutual funds can help in spreading credit risk.
- Operational Risk: While operational risks are typically associated with the internal workings of an organisation, diversification can indirectly mitigate this risk as well. By investing in a diversified portfolio, you're not over-depending on a single company's operational efficiency. If one company in your portfolio faces operational difficulties, the impact on your overall investment is limited.