Understanding financial risk can be a complex subject mostly because everyone seems to have a different definition. Traditionally risk has been defined by a dry and mathematical term called volatility. Volatility being a measure of the dispersion of returns for an investment. Essentially, the amount of uncertainty we have about how the value of an asset may change.
This definition may work well for traders at the stock exchange but it doesn’t fit for the majority of people trying to plan their financial future. It is too abstract and doesn’t take into account the human nature of investing.
When planning your financial future risk has come to be defined as a mix between the risk you are willing to take, your capacity for financial loss and the risk required to meet your goals. Overall these terms are called your risk profile and it is your risk profile that helps determine where to invest and for how long.
Your Risk Profile
The risk you are willing to take (also known as risk tolerance or risk attitude) is a psychological construct and identifies how comfortable you feel when your money is at risk. Your capacity for loss is typically the result of your income and expenses and how much money you afford to lose before your financial goals are seriously threatened. Lastly someone’s risk profile is also determined by how much risk they need to take to meet their goals. These three elements of risk are illustrated below
Risk In the Outside World
Unfortunately, risk doesn’t stop after looking at oneself; you also have to look at financial risk in the outside world. It’s one thing to have a good grasp of the risk you want to take but you also have to look at the myriad of investment options and how they suit your needs. There is more to consider than whether your investment will go up or down in value. Below is an illustration of common investment risks in the outside world.
The Best Financial Plan For Your Future
Making the best financial plan for your future involves understanding risk on two levels. Firstly, what level or risk is appropriate for your circumstances and secondly what are my best options given the inherent risks in all investments. By understanding this you will be able to plot a plan that works best for your future and have realistic expectations about the outcome.
Guest post by John Ndege, the founder of Pocket Risk. Pocket Risk makes risk profiling software for financial planners and advisers.