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Course: Financial Literacy > Unit 6
Lesson 1: What is risk and how to manage itIntroduction to risk and risk management
Life is full of surprises, and sometimes those surprises come with risks for both our daily lives and our finances. Being aware of financial risks, like losing valuable assets or potential earnings, can help us make smarter decisions and protect our financial future.
What is risk?
Risk is the exposure to danger, harm, or loss. When we talk about risk in finance, we are talking about the chance that you could lose assets (like money, home, or car), or lose your earning potential (not make as much as you expected). For example, if you invest your money in a company, there is a chance that the company might not do well and you could lose your money. This would be a loss of an asset.
Another example of a risk would be a construction worker who gets hurt on the job. If the injury is bad enough, the worker might not be able to do the same kind of work anymore and might have to find a new job that pays less money. This would be a loss of earning potential because the worker will no longer be making as much money as they were able to.
Why is risk inevitable and uncertain?
Individuals face risk in their everyday lives and in their financial decisions. There is no way to completely eliminate risk, and there is always some level of uncertainty involved in financial decisions. This is because there are so many factors that can affect an individual's financial situation, such as changes in the economy, job loss, unexpected expenses, or changes in consumer behavior.
All of these factors are outside of an individual's control, and it is impossible to predict exactly how they will affect their financial decisions. This is why it is important for individuals to be aware of the potential risks and to have a plan for managing them.
Risk and return
There is a relationship between risk and return in the world of finance. In general, the higher the risk, the higher the potential return. This is because investors are willing to take on more risk in order to potentially earn more money. For example, a stock that is considered risky might have the potential for a higher return than a stock that is considered less risky. However, it is important to remember that there is no guarantee of a higher return, and there is always the chance of loss.
What is risk management?
Risk management is the process of identifying, analyzing, and responding to risk. This involves looking at the potential risks involved in a financial decision, figuring out how likely they are to happen, and deciding how to respond.
For example, if you are considering investing in a company, you might look at the potential risks involved, such as changes in the economy or competition from other businesses. You might then decide to invest a smaller amount of money or to invest in a different company with less risk.
I am not an investor, do I still have risk?
Yes. There are many different types of financial risks that individuals and families might face. These include:
- Unemployment: the risk of losing your job and not being able to earn money
- Illness, injury, or disability: the risk of not being able to work and earn money because of a health problem
- Liability: the risk of being sued or held responsible for something that causes financial loss
- Property damage: the risk of damage to your home or other property that causes financial loss
- Theft: the risk of someone stealing your money or other assets
- Fraud: the risk of someone tricking you into giving away your money or other assets
- Identity theft: the risk of someone using your personal information to steal your money or other assets
- Inflation: the risk of the value of money going down, making it harder to buy the things you need
- Market fluctuations: the risk of the value of investments going up and down
Correlated and independent risks
Some risks are correlated, meaning that they are related to each other. For example, if you lose your job, you might also be at risk for not being able to pay your bills or for losing your home. Other risks are independent, meaning that they are not related to each other. For example, the risk of identity theft is not related to the risk of property damage.
Insurable and non-insurable risks
Some risks are insurable, meaning that you can buy insurance to protect against the potential financial loss. For example, you can buy homeowners insurance to protect against the risk of damage to your home, or you can buy health insurance to protect against the risk of illness or injury. Other risks are not insurable, meaning that there is no way to protect against potential financial loss. For example, there is no way to insure against the risk of inflation or market fluctuations.
Summary
- Risk is the potential for loss, and financially, it can be loss of assets or loss of potential income.
- Risk is inevitable and uncertain due to the many factors that can affect the value of an investment or the success of a business.
- There is a relationship between risk and return, with higher risk generally offering the potential for higher returns.
- Risk management is the process of identifying, analyzing, and responding to risk in financial decisions.
- There are many different types of financial risks, including unemployment, illness, injury, liability, property damage, theft, fraud, identity theft, inflation, and market fluctuations.
- Some risks are correlated, meaning that they are related to each other, while others are independent.
- Some risks are insurable, meaning that you can buy insurance to protect against the potential financial loss, while others are not.
As you can see, risk plays a large role in our financial lives. Understanding the different types of risks and developing strategies to manage them can help you stay on track to achieving your goals.
Want to join the conversation?
Can return be had without (additional) risk?(7 votes)
Yes. Return on investments can fluctuate. Invested capital can even disappear. Sometimes, though, the risk is worth it.
When, instead of investing, you deposit in some sort of savings account, you have a contract with a bank that guarantees a rate of return (interest), and your deposit is insured.(5 votes)
Dear David Alexander,
why do u take time out of your day to answer peoples questions? I thank you very much for this although i would still like to know why and if u get paid to do it or not(1 vote)
I do not get paid to do this. I just like helping.(16 votes)
so with investing my money in a stock market be good or bad.. Say i invest in iphone and some in google? Cuz thats what im trying to do invest in the stock market make monney back.. I know its a risk but would it be a good one in the long run?(2 votes)
Investing in only one or two companies can add risk that either one or both perform poorly. Many buy funds holding many different companies to help mitigate the risk of any 1 company doing poorly. But if Apple and Google perform spectacularly then you will miss out by buying a diversified fund. If you can afford to risk losing money then buying a riskier investment may be worth it.(1 vote)
Can return be had without (additional) risk?(1 vote)
Can reverse major risk?(0 votes)- I assume this scenario I am about to say depends on the insurance company. Is it possible, while having car insurance and a car you are financing (making monthly loan payments) get into some sort of accident or property damage as to where the insurance company can pay off your car loan, or a large portion of it?
If yes, I now understand why people try to get themselves injured or better yet have their car get totaled.
Just curious if this is true or not?(0 votes)- You know, that might well be insurance fraud, and if not criminal, it's very risky, and probably rather stupid.(1 vote)
Can return be had without risk?(0 votes)- Even breathing is risky, and riding in a car is especially risky. There's no life without risk. Cemeteries are filled with people who no longer risk a thing.(1 vote)