Definition of Risk with Examples

What is Risk?

Risk is the uncertainty surrounding outcomes. We may also refer to it as ‘volatility’ around results. It is possible the investor would not be able to get the desired returns. The uncertainty can go both ways (positive and negative), but the investors are more concerned about the adverse outcomes. 

Although it is often used in different contexts, risk is the possibility that an outcome will not be as expected, specifically in reference to returns on investment in finance. However, there are several different kinds or risk, including investment risk, market risk, inflation risk, business risk, liquidity risk and more. Generally, individuals, companies or countries incur risk that they may lose some or all of an investment. 

In an investor context, risk is the amount of uncertainty an investor is willing to accept in regard to the future returns they expect from their investment. Risk tolerance, then, is the level of risk an investor is willing to have with an investment – and is usually determined by things like their age and amount of disposable income. 

Risk is generally referred to in terms of business or investment, but it is also applicable in macroeconomic situations. For example, some kinds of risk examine how inflation, market dynamics or developments and consumer preferences affect investments, countries or companies.  Additionally, there are many ways to measure risk including standard deviation and variation.

Different Types of Risk

While the term “risk” is fairly general, even verging on vague, there are several different types of risk that help put it in a more concrete context. So, what are some of the kinds of risk, and how do they affect investors or businesses?

1. Business Risk

In a nutshell, business risk is the exposure a company has to various factors like competition, consumer preferences and other metrics that might lower profits or endanger the company’s success.

When entering a market, every company is exposed to business risk in that there are various factors that may negatively impact profits and might even lead to the business’ demise – including things like government regulations or the overall economy. 

Within the general blanket of business risk are various other kinds of risk that companies examine, including strategic risk, operational risk, reputational risk and more. In a larger sense, anything that might hinder a company’s growth or lead it to fail to meet targets or margin goals is considered a business risk, and can present in a variety of ways. 

2. Volatility Risk

Particularly in investment, volatility risk refers to the risk that a portfolio may experience changes in value due to volatility (price swings) based on the changes in value of its underlying assets – particularly a stock or group of stocks experiencing volatility or price fluctuations.

Volatility risk is often examined in reference to options trading, which tends to have a higher risk of volatility due to the nature of options themselves.

Stocks are often given ratings, called “beta,” which help investors detect which stocks may be more of a risk for their portfolio. The beta value measures a stock’s fluctuations compared to the overall market or a benchmark index like the S&P 500.

3. Inflation Risk 

Inflation risk, sometimes called purchasing power risk, is the risk that the cash from an investment won’t be worth as much in the future due to inflation changing its purchasing power. Inflation risk primarily examines how inflation (specifically when higher than expected) may jeopardize or reduce returns due to the eroding the value of the investment. 

In general, inflation risk is more of a concern for investors who have debt investments like bonds or other cash-heavy investments. 

Although inflation risk may not be the primary concern for investors, it definitely is and should be on their minds when dealing with cash flows over a long period of time in investment vehicles or when calculating expected returns. The longer cash flows are exposed, the more time inflation has to impact the actual returns of an investment and eat away at profits – specifically if inflation is at an accelerated rate.

4. Market Risk

Market risk is a broad term that encompasses the risk that investments or equities will decline in value due to larger economic or market changes or events. 

Under the umbrella of “market risk” are several kinds of more specific market risks, including equity risk, interest rate risk and currency risk.

Equity risk is experienced in every investment situation in that it is the risk an equity’s share price will drop, causing a loss. In a similar vein, interest rate risk is the risk that the interest rate of bonds will increase, lowering the value of the bond itself. And currency risk (sometimes called exchange-rate risk) applies to foreign investments and the risk incurred with exchange rates for currencies – or, if the value of a certain currency like the pound goes up or down in comparison to the U.S. dollar.

Example of Risk

There are various types of Risk; the most commonly used example in the banking sector is ‘Credit Risk’. The core operations of a Bank involve lending out money to governments, corporates and individuals. When the Bank lends out money, there is always a possibility the debtor gets default and does not return the money. Here, the Risk of not getting the money back is an example of Risk in a financial term. 

Why is it essential to know Risk?

The definition of Risk forms the foundation of Risk Management. The purpose of Risk varies from sector to sector and organisation to organisation. Hence, it is critical for Risk Professionals to understand the concept of Risk well.

There are several approaches that investors and managers of businesses can use to manage uncertainty. Below is a breakdown of the most common risk management strategies:

1. Diversification

Diversification is a method of reducing unsystematic (specific) risk by investing in a number of different assets. The concept is that if one investment goes through a specific incident that causes it to underperform, the other investments will balance it out.

2. Hedging

Hedging is the process of eliminating uncertainty by entering into an agreement with a counterparty. Examples include forwards, options, futures, swaps, and other derivatives that provide a degree of certainty about what an investment can be bought or sold for in the future. Hedging is commonly used by investors to reduce market risk, and by business managers to manage costs or lock-in revenues.

3. Insurance

There is a wide range of insurance products that can be used to protect investors and operators from catastrophic events. Examples include key person insurance, general liability insurance, property insurance, etc. While there is an ongoing cost to maintaining insurance, it pays off by providing certainty against certain negative outcomes.

4. Operating Practices

There are countless operating practices that managers can use to reduce the riskiness of their business. Examples include reviewing, analyzing, and improving their safety practices; using outside consultants to audit operational efficiencies; using robust financial planning methods; and diversifying the operations of the business.

5. Deleveraging

Companies can lower the uncertainty of expected future financial performance by reducing the amount of debt they have. Companies with lower leverage have more flexibility and a lower risk of bankruptcy or ceasing to operate.

It’s important to point out that since risk is two-sided (meaning that unexpected outcome can be both better or worse than expected), the above strategies may result in lower expected returns (i.e., upside becomes limited).