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Financial risk is the likelihood that a financial decision you make will result in a negative or undesired outcome. There are risks to every financial decision you can think of—from investing to buying a home and even filing your taxes. Risk isn't all bad, though. In fact, some risk is necessary to get the return and gains you want out of your financial decisions.
Risk can't be totally eliminated, but if you manage it well, it can help you reach your financial goals. Here's what you should know about managing financial risk.
Types of Financial Risk
There are many types of financial risks, including:
Investment risk is the probability that you'll take a loss on an investment. The loss can come from an adverse event that causes you to lose money. This can be a drop in value, a change in your personal finances that causes you to pull out of an investment prematurely or some similar event for investments such as stocks, bonds or real estate.
Inflation happens when an asset loses purchasing power or value. Inflation risk is a consideration when you have an asset you expect to appreciate, or at the very least, retain value. If your investment can't beat inflation over time, you're essentially losing money on it.
For instance, you need to consider inflation when saving for retirement. Otherwise, your savings may lose enough value that you won't be able to maintain your quality of life in retirement.
Credit risk is the likelihood that a borrower won't be able to repay money they've borrowed. Consumer credit risk is measured using credit scores, with higher credit scores signaling lower credit risk—and vice versa. You can check your credit score for free through Experian.
Typically, if you present significant credit risk, a lender will put stricter terms on your debt in the form of a higher down payment, higher interest rate, collateral requirement or shorter terms—if they grant you credit at all. As a borrower, you can decrease the amount of risk you present to lenders by handling your credit accounts responsibly, including paying all bills on time, keeping balances low and applying for credit only when you need it. As a creditworthy borrower, you'll receive better loan terms, which reduces the cost of borrowing money.
How to Minimize Risk
Here are tips on minimizing financial risk when making financial decisions.
Choose Lower-Risk Investments
Choosing lower-risk investments may slow your financial progress, but your risk of loss will be lower as well. Determine your level of risk tolerance and choose investments that match your appetite for risk.
An example of a lower-risk investment could be a blue-chip stock versus a tech startup stock. Savings accounts and bonds are also seen as lower-risk investments, but they will not gain value as rapidly as other, riskier assets.
Know Your Risk Tolerance
Understanding how much risk you can comfortably shoulder when it comes to your finances can help you make better-informed decisions. For instance, a younger person might feel comfortable putting their retirement savings in higher-risk investments such as stocks, whereas someone closer to retirement might take a conservative approach and move a significant portion of their savings to bonds.
When considering a new investment, weigh it against your comfort with risk and also how long you plan to hold the investment. If there's an imbalance, look at other options. If you are knowledgeable about a certain asset class or have experience with a certain investing approach, this can also help to minimize your risk more than if you are inexperienced. If you're unsure about how to invest, consider consulting a financial advisor, who can help you hone your strategy and choose appropriate investment vehicles for you.
Diversification means you are using a variety of financial approaches, products and assets to achieve your desired financial outcome.
This can apply to any financial area of your life. You can diversify things like:
- Investment assets such as stocks, real estate or cryptocurrency
- Income sources
- Financial products like credit cards or deposit accounts
For some, it may make sense to have multiple sources of income to hedge against the risk of job loss. For others, mitigating risk may look like spreading investments across multiple asset types or industries.
Some risk is likely required to meet your financial goals. So instead of avoiding risk altogether, you can take "calculated" risks that align with your own risk tolerance. With some research, analysis and number crunching, you can arrive at a decision based on your assumptions—with the understanding that there's a chance of an undesired outcome.
Some examples of managing risk include:
- Paying down debt and increasing your savings
- Using only a portion (rather than all) of your savings to invest in a business
- Spreading out your retirement investments among growth stocks, mutual funds and bonds
- Putting only a small percentage of your savings into volatile individual stocks or cryptocurrency
The Bottom Line
Balancing risk with the potential for reward can involve making many different decisions, from where to buy a house to how to invest for retirement. Generally speaking, taking big risks can produce big rewards, as well as big losses. Make your financial choices based on your risk tolerance as well as your investment timeline. If you feel like you need help, consider hiring a financial planner or taking advantage of resources your employer or local community offers.