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Terms you need to Know in order to Understand Financial Risk

Published on August 20, 2014, by in Personal Finance.

When it comes to investing there are a lot of terms that you really need to know in order to be able to make educated decisions. Many of those terms deal with the financial risk that you take when investing, and knowing those terms is vitally important to your success. Below you’ll find the most important financial risk terms that you need to know. Enjoy.

Probably the most important term is Market Risk or what’s known as “principal risk”. This term refers to the chance that a downturn in the market, or a bad investment, lowers the value of any asset you might have. It’s used mostly for stocks and bonds.

At the other end of the spectrum from market risk is Risk of Avoiding Risk. This usually applies to investors who are too conservative and whose investments don’t grow fast enough to keep up with inflation.

Many consumers seek the elusive risk-free return by putting their money into CDs. The problem with this is Interest Rate Risk, which you face if your assets get stuck at a below average rate of return because interest rates have risen.

One term that applies to an individual more than the market is Shortfall Risk, the risk that an investor won’t have enough money to make their goals. Being too conservative or, on the other hand, too aggressive, can open an investor up to shortfall risk. For consumer that doesn’t believe their portfolio is strong enough, saving more is the key to addressing shortfall risk.

A similar term is Special Situation Risk, which applies to an individual investor with special needs like a wedding, home purchase or college costs. A couple that is so worried about paying college for their child that it distracts them from saving for their own retirement, for example, is suffering from special situation risk.

Timing Risk is similar to special situation risk in that it depends on the individual investor as well as the specific timing that they’ll need to keep up with in order to have enough money by the time a specific event occurs. For example, if an investor is going to be purchasing a home in four years but it doesn’t appear that their stocks will make enough money to enable them to do that, their timing risk is high.

If government decisions could possibly damage the value of any of your investments or assets, you have Political Risk. Obamacare, tax law changes and changes to Social Security are all specific political risks in that all of them may negatively affect your investments.

Looking at everything from a “big picture” perspective, Societal Risk is the risk that your assets and investments face due to world events like terrorist attacks, wars and natural disasters.

Unless you’re a complete newb  investor, you should already know that Diversification is one of the best ways, if not the best way, to lower your risk from any of the factors above. Diversification means simply spreading your money around in different assets and asset classes so that, if one were to falter or fail, the others will still continue to grow, keeping you from losing everything.

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