The ABCs of risk

A recent assessment of adults in the United States found that “risk” is one of the personal finance topics for which respondents have the least understanding. This is likely due in part to the fact that it is imprecisely defined and can be used to refer to a wide range of situations. A firm grasp of the concept, however, can help you make better financial decisions.

So what is risk? At its most basic, risk is a state of uncertainty where someone or something is exposed to danger, harm, or loss. In general financial terms, risk means the potential loss of money, assets, and/or value due to personal, social, and market conditions and decisions.

There are many types of risk. Here are a few concepts to get you started.

• Economic risk: exposure to gain or loss due to changing economic conditions, such as a period of growth or decline
• Insurable loss: exposure to loss that is a pure risk faced by a large number of people, when the amount of the loss can be predicted
• Liability risk: exposure to loss when your actions result in injuries to others or damages to their property
• Personal risk: exposure to loss associated with something of personal value, including income and standard of living
• Property risk: exposure to loss associated with your personal property, such as your home or car, and sometimes due to the actions other people or acts of nature
• Pure risk: exposure to a loss that has no chance of a gain, such as an act of nature
• Speculative risk: exposure to loss or gain based on purchase of or investment in gold, futures, options, or commodities

Why does this matter? Although these concepts may seem complex, an understanding of risk should underlie all your personal financial decisions. It allows you to evaluate your own risk tolerance, i.e. your comfortwith assuming various levels of risk. With this information, you can evaluate your capacity for coping with potential financial loss, i.e. your abilityto assume various levels of risk. Combined, this knowledge can guide your decisions and your conversations with financial advisors. Remember, the more risk you’re willing to take on, the greater your potential returns and losses. How will you protect your assets given your personal risk tolerance? And how can this new understanding help you better meet your financial goals?