5.1 Introduction to Financial Risk

In our previous chapters, we have often used the term risk. Risk means uncertainty. For example, when you hit a lofted shot while playing cricket, there are some elements of uncertainty. You may completely miss the ball and get clean bowled. You may edge the ball and get caught behind. You may not time the shot well and get out caught by one of the fielders. But if your shot connects with the ball perfectly, it will fetch you six runs. The six runs are the returns, and getting bowled or caught out are the risks in this instance.

Ensuring the risk taking ability of investment

Similarly, when it comes to your investments, some risks may prevent you from getting the expected returns or, in worst cases, cause losses. Some risks are by causes beyond our control, and the others are due to the inherent nature of the investment itself. Risks are neither evenly spread across all investments nor all the investors in the same mode of investment. In most cases, investments with higher risks will provide higher returns. Therefore, you must consider your risk-taking ability or risk appetite while building your investment portfolio.

Our explanation of financial risk focuses specifically on the risks that may impact the returns of your investments. In other words, we would focus on individuals’ risk perception. The same elements of financial risk may affect other entities like the regulatory authorities, other operators in the market, the government, etc. Generally, if a particular aspect of risk affects the entire market, some measure will help avoid or eliminate it. These measures are called risk mitigation measures. For the individualistic risk elements, risk mitigation must be looked at by the concerned individual entities themselves. Also, where risks are certain, they generally are factored into the returns. Hence, we say the higher the risk, the higher the reward.