The risk of losing money is an inherent aspect of investing. The process of assessing and measuring risk to determine an investment’s potential viability, as well as coming up with ways to potentially mitigate certain risk factors, is called a financial risk analysis or financial risk assessment.
A financial risk analysis is important to many investors because it can help them gauge an investment’s potential merits and rate of return – key factors for investors to consider when deciding whether a particular investment warrants their attention and investment capital.
Let’s take a closer look at what compromises a financial risk assessment.
Components of Financial Risk Analysis
Think of risk analysis as forecasting. When you undertake a financial risk analysis, you are assessing and analyzing various market, environmental, regulatory and governmental risk factors for the probability that a particular course of action or a potential shift in policy could adversely affect your investment dollars. The goal of the analysis is to strike an acceptable balance between these potential risk factors and your expected returns to determine if an asset represents a viable investment opportunity.
Professional risk analysts use several different methods to help their clients identify, assess and potentially mitigate risk factors. These include quantitative mathematical modeling that attaches a numerical value to risk, as well as using intuition and experience to build conceptual risk models. These methods can help investors determine what factors could potentially affect their investments, the severity of risk factors, and the possibility that they might occur.
Risk factors that are taken into account typically include:
- Liquidity risk
- Market risk
- Credit risk
- Concentration risk
- Inflation risk
- Horizon risk
- Operational risk
It’s important to note that each of these factors involves a certain degree of uncertainty, and there’s no way of knowing if any one or all of these risk factors will negatively affect an investment. One or two of them could incrementally raise the risk profile of an investment, while many of them working in tandem could lead to significant loss of investment capital. That’s why a financial risk analysis is a bit like looking into a crystal ball – you hope to see a clear picture, but the outlook will always be a bit cloudy.
The Bottom Line
A financial risk analysis isn’t perfect science. It can, however, help investors narrow down how much risk they are willing to take on versus the amount of risk they actually need to reach their financial goals. It also can help determine how much risk you currently have in your investment portfolio. This type of assessment can help investors better match their investment goals and expectations for yield against their tolerance for risk.
