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How Do I Analyze Investment Risk?

Anything beyond basic investment risk analysis might be best handled by Wall Street.
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  • Written By: Adam Hill
  • Edited By: Bronwyn Harris
  • Last Modified Date: 17 August 2014
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Although levels of risk vary, there is risk present whenever an investment is made. Investment risk can be analyzed using a number of parameters, and even though some analysis is best left to Wall Street, the fundamentals of analyzing investment risk are rooted in common sense and can be understood by anyone who wants to invest money. There are some categories that describe types of investment risk, and these categories shed light on ways to protect oneself from financial misfortune.

The first type of investment risk is sometimes called valuation risk. Put simply, this means that at certain prices, an investment may be a good one, but not at other prices. The risk is that a person can buy a good investment at a bad price. This form of risk applies to every type of asset, including real estate, stocks, and bonds.

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In the case of real estate, a family may have found a wonderful home to buy- the right size, a good location, etc. However, if the price is far outside of the range that the family can afford, this “good” investment would not be a good financial decision for the family. In the case of stocks, a company may have excellent profit margins, good growth, and a strong brand, but if it is trading at a price that is too high given the company’s earnings, then it may not be a good investment. The question to ask when analyzing this type of risk is not whether something is a good investment, but whether it is a good investment at the current price.

The example of the good company with over-priced stock leads into the best-known category of investment risk, called business risk. Business risk is easily understood and is somewhat intuitive, even for someone unfamiliar with business and finance. Basically, business risk is present when there is a potential that an investment will lose value because of competition, financial trouble at the company, or poorly managed resources. It is most common to see this type of risk present in the stocks of publicly traded companies.

It is easy to see why a news story about a company reporting a large operating loss, or some type of corruption within the management, will send the company’s stock price lower. When an investment is a small piece of ownership in a company, in the way that a share of stock is, its value will generally increase or decrease with the company’s performance and perceived value. Some industries are prone to higher levels of business risk, and this is something to take into consideration when investing. The best defense against business risk is to invest in a company that is able to stay afloat in hard times by raising prices, because the company’s product is known for quality or dependability.

All investments carry at least some degree of risk. Even investments that are said to be riskless, such as those that are government-backed, can lose value due to inflation, and this is appropriately known as inflation risk. The presence of risk is universal, and should never be considered a reason for not investing at all. Indeed, that course of action may be the one with the most risk of all.

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