In financial planning, the key to developing a sound portfolio and reaching your financial objectives lies in your ability to strike the right balance between potential risk and the rewards possible. Based on your financial objectives, financial situation and investment
style, you should choose from among investment
alternatives, all of which may vary greatly in the degree and type of risk and return potential.
Risk is the possibility that you may lose some or all of your investment
, or that your investment
may not increase in value. When investing, you face the different types of risks, such as market risk, credit risk, inflation risk, reinvestment risk, liquifity risk, political risk, economic risk, industry risk and others.
Market risk is about the potential of an investment declining in value. As a result, if you have sold the investment, you would receive less than what you initially paid. Credit risk arises when the issuer of an investment instrument fails to live up to its financial obligations. A default by the issuer means loss of expected interest payments. Inflation risk occurs when the value of a long-term asset may not grow enough at the same pace as the rate of inflation, thereby reducing your purchasing power or causing erosion of wealth.
Reinvestment risk arises when interest rates fall at the time of maturity of an investment. Then, you may be unable to reinvest the matured assets at the usual rate of return. Another risk is liquidity risk when you are unable to liquidate an asset when you want and at the price you want. Under such circumstances, you may be forced to retain the asset or accept less. Economic risks involves a sudden downturn in the economy, affecting financial markets across the board. Similarly, industry risks involve occurrence of challenges for a specific industry, often related to the one that experiences problems will suffer as well. That apart, there could be national, international, political or geopolitical risks when a country’s government may suddenly change its policies leading to changes in tax structures or events that could hurt an asset class.
These risks are taken into to calculate something called the risk-return ratio, which is used by many investors to compare the expected returns on an investment to the amount of risk undertaken to capture these returns. The ratio is calculated mathematically by dividing the amount of profit the trader expects to have made when the position is closed by the amount he or she stands to lose if price moves in the unexpected direction.