The Finance Professor: Understanding Risk

My father-in-law's late business partner always said, "The world is in the hands of the risk takers."

Risk, like volatility, is another one of those investment terms that tend to get thrown around very loosely.

Personally, I believe that risk, like beauty, is in the eyes of the beholder. In this edition of "The Finance Professor," I will explain several basic forms of risk to help prepare you for the next lesson, which will cover how you can manage risk.

What Is Risk?

Risk is not a single element but rather a collection of hazards that when taken together expose an investor to adverse consequences. Risk plays a role in many facets of our lives, including our health, our career, our investments and several others. (I will focus in on the investment risk and leave the other risks to other experts.)

Every person has his or her own level of risk tolerance . In investment terms, increased levels of risk usually imply greater potential for financial benefit. We refer to this as the risk/reward relationship. There is good risk and there is bad risk. It's kind of like cholesterol (LDL vs. HDL). You must factor out the bad risk and focus on the good risk. When you're able to make this separation, you can ensure that the level of risk that you assume falls within your comfort zone.

As an individual investor, some basic risks you should be cognizant of before and after you make any investment decision are:

• Market risk
• Systemic risk
• Interest rate risk
• Credit risk
• Counterparty risk
• Sovereign risk
• Estimation risk
• Extrapolation risk