Risk

Risk means uncertainty about the result of some action or situation. People react differently in uncertain situations according to their nature. We can reduce financial risk by being responsible and aware, by insuring ourselves and by saving money "for rainy days". Risk in a financial market context can be defined as the chance that an investment will provide a low or negative return.

Risk

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Prediction and probability

We usually talk about risk when we are unsure of how a certain situation will develop:

Will I realize high profit from my investment?
If I want a high return on my investment how much risk am I willing to take?
Will I lose my savings due to financial instability of my bank?

See how people decide based on the probability of different consequences. Some situations are more predictable and risk can be avoided:

You know your bank is new on the market and that it invests its free capital to volatile stock funds. Even though it offers high profit, you probably won’t put all your savings on their accounts. You predict that the bank might go bankrupt for its unsafe investments and do not want to risk losing all your money.

Some situations are unpredictable and you can only try to lower the possibility that undesirable consequences will occur: - You invested a big amount of your savings to a conservative deposit fund by a very stable bank that has branches all over EU. An unexpected/unpredictable situation occurs when the banks’ officials allow bad investments that deeply affect the bank’s cash flow. You will not get any dividends that year.

Behaviour under uncertainty

In economic theory, we recognise three different types of personalities according to their relationship to risk:

risk-averse – people who do not bear risk well and always try to avoid it; they prefer low, but certain profit
risk neutral – people who take risk sometimes, especially if there is at least a 50 % chance of higher profit
risk-seeking – people who love taking risks, who search for risk and danger, they take the risk of loss even though the percentage of gaining high profit is very low
optimism bias is a new concept - people tend to be over-optimistic about the outcome of planned actions.

Sources of risk

We encounter risk in all areas of finance – from saving and investing through paying in different ways, to borrowing. Insurance is probably the most common area to talk about risk but not the only one.

Financial risks come from different sources: - risk of theft, loss or damage of personal property;

risk of illness, injury or accident;
risk of change in life situation – unemployment, retirement, loss of a partner;
risk of liability for damages caused to third persons;
risk of identity abuse;
risk of payments (over internet, with payment cards);
risk linked to saving and investing;
risk linked to excessive gambling.

How can we reduce risk?

by being responsible, aware and prepared:
take informed choices, compare offers;
evaluate your investment goals;
assess how much money you are able to invest;
determine the level of risk you are willing to take;
read your offers / contracts / bank statements carefully;
diversify your savings / investment portfolio - by diversifying in different plans you will be putting your money into different investment instruments whilst ensuring that you don’t lose it all at once - ’don’t put your eggs all in one basket’;
when contracting financial services in foreign countries, make sure you are familiar with local legal system and language;
by insuring – see factsheet Insurance for further information
by saving for a rainy day e.g. you never know when your computer/mobile will break or get lost - it is wise to have some spare money to be able to buy a new one quickly.

Investment and risk Simply put, risk is the possibility of losing some or all your investment. Each investor has a different risk tolerance. A conservative investor will probably search for opportunities that offer safety and some measure of control on the return. Conservative investors will opt to skip high-growth investments by keeping their money in investments with more secure rates of return. On the other hand, aggressive investors will take some chances with a volatile or fluctuating market in the belief that they have the opportunity to receive a greater return on their initial investment. Alternatively there are those investors who fall between the agreesive and conservative, who may choose to invest in investments which are both risky and conservative. Anyone who wants to save or invest should follow the the magic triangle of investing and ask him/herself the following questions: