Understanding Financial Risk

Financial risk carries a psychological toll that varies from person to person, leading many potential investors to stay away from financial markets instead of taking precautionary actions that can minimize risk while still generating stable returns.

I was 13 years old when I first started investing in the stock market, amazed by the enormous amounts of money I saw people like Warren Buffett and other prominent investors making. Inspired by their returns, I made my first investment in the nuclear energy industry — I wanted to put my money into something complex so I'd sound smart, rather than actually understanding the company or sector I was buying into. After disregarding every financial precaution for risk known to mankind, my small investment of $60 dropped over 66% in a single week.

Many people today, young and old, stray away from the stock market's amazing opportunities because they don't understand risk. This article aims to define what financial risk is and how understanding it will let you make smarter decisions — and potentially avoid what happened to me as a kid.

The amount of financial risk one should take is subjective, and it can be mitigated by investing across different asset classes and sectors.

What Is Financial Risk?

Money is something deeply personal that affects our lives every day. So putting your hard-earned time,which is represented as dollars, into an investment vehicle that has the potential to turn it into a larger sum, while also carrying the chance of losing it, can seem scary and almost as irrational as gambling.

Financial risk is widely defined as the possibility of losing money on a business venture or investment. The way I like to think of it, though, is as the spread of uncertain outcomes.

Every investment has a number of factors contributing to the rise and fall of its valuation (what the investment is worth according to the math). Each risk factor an investment faces can be labeled as a different subset of risk (which I'll explain in the further reading below), and some investments carry a wider spread of uncertain outcomes that can sway the stock's value.

An Example: Two Risk Profiles

For example, let's look at two companies with risk profiles anyone could account for: JP Morgan (a bank that has financed America for years and holds a lot of other assets) and Oklo Inc. (a nuclear fission reactor company burning cash through research and development).

If a stock represents ownership in a company, which one would you rather own? If you had held either of these companies since 2024, here's how your money would have been affected:

As you can see, while you would've made more money investing in Oklo Inc., you would have had to stomach watching your money drop over 70% from its peak price. Oklo going up doesn't mean it was a good investment — its wide range of possible outcomes just happened to land on the good side. It's important for retail investors (investors who aren't trading at an institutional level) not to confuse good outcomes with good opportunities.

JP Morgan investors, on the other hand, didn't have to watch their money drop over 30% in a single month. The gains may have been lower (compared to Oklo's 240%), but investing in JP Morgan in 2024 would have been a safer bet because of its lack of volatile price movement.

How Risk Is Avoided

This principle of making safer investments comes down to two kinds of risk: systemic risk (recessions, interest rates, war, and other crises) and my personal favorite, idiosyncratic risk (risks specific to a company — lawsuits, earnings reports, management, and so on).

Systemic risks affect almost every asset class available for purchase and can't simply be reduced by a change of strategy. Idiosyncratic risk, however, can be reduced through strategic selection of companies.

Selecting companies based on their risk factors is the entire game of finance, and there are two ways to go about it: qualitative and quantitative. There are many different ways to analyze and assess risk, but this article is focused on those who don't have much experience with securities, so I'll digress.

The simplest way to avoid idiosyncratic risk is through an index fund — an asset that lets you invest in a fund that mimics the performance of the overall stock market. While you're still exposing yourself to systemic risk, the volatility of the overall market tends to remain low, and systemic risk is far more foreseeable.

Why People Are Scared of Investing

Once again, money is deeply personal to people, so when they lose it, they remember those losses — and other people remember them too.

Take the most recent major financial crisis, the COVID-19 pandemic. When the pandemic was declared, businesses closed, people died, and fear surrounding the global economy was at an all-time high. Because people were so afraid, they sold their holdings — at the lowest point they could. People lost everything, and it was one of the most heartbreaking financial crises of our modern era.

But global governments and central banks started lending money at near-zero interest rates to citizens and businesses, repairing the damage at almost record speed.

So while some people were selling their assets and locking in permanent losses, others were buying and staying psychologically sound through that period. Instead of being devastated and ruined by the pandemic, they actually came out richer.

So when the market goes through its oscillating economic cycles, remember the systemic risk you're taking when you invest, and plan for the future.

What Is Financial Risk?

An Example: Two Risk Profiles

How Risk Is Avoided

Why People Are Scared of Investing

Further Reading for the Intelligent Investor