To know what risk assessment is and why it is done, it is first important to know what investment risk is. Investment risk is the likelihood of a loss occurring which is relative to an expected return on the same investment.
In simple words, it is a measure of the level of uncertainty of getting a return on an investment as per the investor expectations. It is basically the extent to which the unexpected result could be realized.
The risk is important and it helps to assess the investment prospects.Most of the investors when making an investment want the less amount of risk. When the risk is less the investment is seen to be more beneficial. However in reality when the risk is higher so is the return.
Risk assessment is very important in financial planning and you need to define and document what the risk is in order to get a better outcome. Knowing what the risks are will not make the future certain but instead, it will give you some amount of comfort when you see that a systematic method has been applied to help you manage your risks.
Risk assessment is explained
The risk and financial planning are basically divided into three broad headings. They are:
The investor’s tolerance to risk – This seeks to explain how much volatility the investor is comfortable with. This is based on his past experiences and also what his future expectations are.
The investor’s capacity to take the risk – This is basically the client’s ability to take losses or how they would be impacted if there was a huge gain or a huge loss on their investment
The firms do a risk assessment and risk rating by using a psychometric risk tolerance test.
Risk assessment and how it helps in investments
There is a methodical approach that is followed in investing. When an investor is assessed for his risk-taking ability then he would be asked to answer some questions like if he is ready for a yearly return of say 10% yearly or a return of 30% in a year and is comfortable losing 20% in a year. Based on what the assessment score is an investor is recommended a particular asset class to save money into.