By Aaron Brown

Part of Financial Risk Management For Dummies Cheat Sheet

Thinking about financial risk tends to induce tunnel vision, especially in the wake of a market downturn or when you fear market uncertainty. However, risk, danger and opportunity are closely aligned aspects of uncertainty, and you need to consider each aspect as you make investment decisions:

  • Danger is one-sided uncertainty. Danger produces only bad surprises, and its results aren’t measured in money or anything else that can be aggregated. Dangers should be minimised, subject to constraints.

  • Risk is a two-sided uncertainty – both good and bad surprises are possible. Results of risk can be aggregated. Your goal is to optimise risk by choosing the right level for your circumstances. Don’t reflexively choose low risk for predictability or high risk for excitement.

  • Opportunity is one-sided again, bringing only good surprises with unquantifiable results. Maximise your opportunities, subject to constraints.

People tend to overestimate the probability of bad events (dangers) and fear dramatic but unlikely ‘movie plot’ scenarios while underestimating the probability of something unprecedented and unexpected happening (risk).

As you make financial decisions, consider the types of risk you may encounter that can affect your strategy:

  • Market risk: Uncertainty due to changes in market prices.

  • Credit risk: Uncertainty due to a failure of an external entity to keep a promise.

  • Operational risk: Institutional uncertainties other than market or credit risk.

  • Liquidity risk: Uncertainty about terms and the ability to make a transaction when necessary or desired.

  • Funding risk: Uncertainty about whether investors will provide sufficient funds.

  • Reputational risk: Uncertainty about how your entity will be perceived.

  • Political risk: Uncertainty about government actions.

Make sure you consider the range of risks, and if everyone is thinking about the market risk, take a minute to think about reputational risk or funding risk as well.