Risk is unique in that it applies to the probability of losses occurring, and the potential value of those losses.
In finance, risk is considered a type of cost.
All decisions you make have some degree of inherent risk.
Inaction too often has the greatest amount of risk, so rather than becoming paralysed by attempting to avoid all risk, look at it as a type of cost that allows you to calculate whether a financial decision will reap greater benefits that the potential losses and to compare the available options.
There are a variety of different ways to:
- avoid risk,
- reduce risk, or
- even share risk.
Each of the above has a price.
By calculating the cost-value of specific risks, it becomes possible to determine whether any of the tools available for managing risk are financially viable and are themselves an appropriate risk.
Risk management is a critical part of financial success.
You should explore:
- the different types of financial risk,
- the ways in which risk is measured and
- how to effectively manage the amount of risk to which you are exposed.
Additional notes
Ways to avoid risk: diversification and appropriate use of derivatives
Ways to share risk: insurance
In the end, the best tool you have available to you in limiting the costs associated with risk is simple due diligence.
- Do your research, make decisions which make sense to you and keep watching so you know when that decision doesn't make sense anymore.
- If someone's credibility is in question, risk mitigation can come in forms as simple as asking for a nonrefundable down-payment, just as banks will sometimes ask for collateral before issuing loans.
- Preparing for losses can be as simple as keeping enough funds available in a liquid form so you can pay your bills until you regain your losses.
- The duration of your exposure to losses can be shortened by ensuring you always have an exit strategy - before you commit to a decision, develop a way to undo it in a worst-case scenario.
Like most things, you get out of risk management that you put into it, and as the amount of potential risk increases, so should your intolerance for sloppy risk management.
