Risk is the effect of uncertainty on an objective.

In finance, risk is the possibility that an investment, financial plan, or business decision produces an outcome different from what was expected. That outcome may involve a loss, unexpected cost, delay, missed opportunity, or failure to achieve a goal.

Risk cannot be evaluated properly without knowing what someone is trying to accomplish.

An investment that may be suitable for a long-term retirement goal may be unsuitable for money needed within a few months. The risk depends not only on the investment or decision, but also on its purpose, timing, and potential consequences.

The key question is: Risky in relation to which objective?

Volatility measures how much the price or value of an asset changes over time.

Risk is broader. It may include:

• Losing some or all of an investment.

• Failing to earn enough to reach a financial goal.

• Having to sell when prices are down.

• Being unable to access cash when needed.

• Receiving an outcome that is worse than the plan requires.

Volatility can be one way to measure investment risk, but it is not the same as risk. A temporary price decline may not cause permanent harm, while a stable-looking investment may still be risky if it cannot keep pace with inflation, cannot be sold when needed, or does not support the investor’s objective.

1. Market Risk

   • The possibility of loss caused by changes in stock prices, interest rates, exchange rates, or commodity prices.

2. Credit Risk

   • The possibility that a borrower or counter party will fail to make a required payment.

3. Liquidity Risk

   • The possibility that an asset cannot be sold, or a financial obligation cannot be funded, when required and at a reasonable value.

4. Operational Risk

   • The possibility of loss caused by failed processes, people, systems, or external events.

5. Solvency Risk

   • The possibility that an individual or organisation cannot meet its financial obligations and remain financially viable.

These risks can overlap. For example, a market decline may reduce the value of assets and create pressure to raise cash.

A useful risk assessment considers two basic questions:

• Likelihood: How likely is the uncertain event to occur?

• Impact: What would happen if it did occur?

A risk with a low likelihood may still require attention if its potential impact is severe. Likewise, a frequent event may be manageable if its consequences are minor.

Risk assessment must also consider the objective, time horizon, available resources, and existing controls.

A practical risk-management process is:

1. Define the objective.

2. Identify what could affect the outcome.

3. Assess the likelihood and potential impact.

4. Decide whether to avoid, reduce, transfer, accept, or deliberately take the risk.

5. Monitor the risk as circumstances change.

Risk management does not mean eliminating every uncertainty. It means understanding the exposure and deciding whether it is appropriate.

Risk appetite is the amount and type of risk a person or organization is prepared to accept while pursuing an objective.

Risk tolerance is the amount of variation or potential loss it can withstand.

In personal financial planning, a person’s overall ability to take investment risk depends on both:

• Willingness: How comfortable they are with uncertainty and potential losses.

• Capacity: Whether their financial circumstances allow them to withstand those losses.

Someone may be comfortable with investment losses but lack the savings, income, or time horizon to recover from them. In that situation, willingness and capacity do not match.

Suppose you need money for a home purchase next year.

An investment that can lose value during that period may create significant risk, even if it has a reasonable long-term return history. The main concern is that the money may be worth less when it is needed.

For a long-term retirement goal, the analysis may be different. Short-term fluctuations may be manageable if the investor has sufficient time, diversification, and financial capacity to remain invested.

Risk should always be measured against the objective.

Risk cannot be eliminated. It can be identified, assessed, accepted, reduced, transferred, and monitored.

Understanding risk helps people and organisations make deliberate decisions instead of reacting after uncertainty creates a problem.

The goal is not to avoid every risk. The goal is to take risks that are appropriate for the objective and manageable for the person or organisation taking them.

1. Government of Canada, Treasury Board of Canada Secretariat. “Guide to Risk Statements.”

2. Government of Canada, Treasury Board of Canada Secretariat. “Framework for the Management of Risk.”

3. Government of Canada, Treasury Board of Canada Secretariat. “Guide to Integrated Risk Management.”

4. CFA Institute. “Introduction to Risk Management,” CFA Program Level I Portfolio Management curriculum.

5. CFA Institute. “Basics of Portfolio Planning and Construction,” CFA Program curriculum.

6. FP Canada. “Financial Planning Body of Knowledge, Topic 08: Investments.”