What Is Financial Risk?

People save and invest money to beat inflation and grow wealth. Of course, managing risk is part of the wealth-building equation. Identify primary financial risks confronting investors, prior to making decisions.

Financial risks are associated with developments that lead to investment losses. Furthermore, each investment decision must be weighted against the performance of other investments. According to The Economist, opportunity cost includes the risk of foregoing profits from other potential investments. For example, cash reserves carry the opportunity costs of missing out on profitable stock market investments that may have been made with the money.

Financial risk is tied to business failure. Stocks, bonds, and mutual funds rely upon underlying businesses to earn profits. Financial assets deteriorate in value as businesses struggle. Businesses undergo financial hardship for lack of financing, poor strategy, or unfavorable legislation.

Business risks increase amidst both recession and economic bubbles. Economic growth may cause investors to overpay for assets. Expensive asset valuations eventually fall and cause losses. Meanwhile, recession causes business failure and investor panic.

Investors diversify, purchase insurance, and use derivatives to hedge against risk. Options and futures are derivatives that lock in prices for assets. Meanwhile, the Federal Reserve coordinates monetary policy to balance growth against inflation in the economy.

Contrary to popular belief, all financial transactions carry risk. Even cash reserves are subject to inflation, which reduces purchasing power over time.