Risk Assessment

What is 'Risk Assessment'

Risk assessment is a general term used across many industries to determine the likelihood of loss on a particular asset, investment or loan. The process of assessing risk helps to determine if an investment is worthwhile, what steps may be taken to mitigate risk and, through specific ratios, the upside reward compared to the risk profile. It determines what rate of return is necessary to make a particular investment succeed.

BREAKING DOWN 'Risk Assessment'

Examples of formal risk assessment techniques and measurements include: conditional value at risk-cVaR, used by portfolio managers to reduce the likelihood of incurring large losses; loan-to-value ratios, used by mortgage lenders to evaluate the risk of lending funds to purchase a particular property; and credit analysis, used by lenders to analyze a potential client's financial data to determine whether to lend money, and if so, how much and at what interest rate.

Risk Assessments for Investments

For investments, whether at the institutional or individual level, there is always a certain amount of expected risk. This is especially true of nonguaranteed investments such as stocks, bonds, mutual funds and exchange-traded funds (ETFs). A generally accepted norm in investing is that without risk, there is no reward.

Standard deviation measures the dispersion ratio around a central tendency; essentially how much plus or negative movement can be expected from a central statistic. As an example, the Standard & Poor's (S&P) 500 Stock Index as represented by the SPDR S&P 500 ETF (NYSE: SPY), presents a three year return of 11.14%, as of May 2016, and a standard deviation of 11.32% over the same period. Although the fund returned 11.14% return over the entire period, its variation within the period could have represented a return of negative 0.18% or a positive 22.46% return, 70% of the time for one standard deviation, according to statistical theory.

Risk Assessments for Lending

Lenders for personal loans, lines of credit and mortgages also conduct risk assessments on their clients, generally referred to as a credit check. If a person's FICO score is under 600, many home loan companies may not lend to him, based on this nationally recognized credit risk measure. A lenders credit analysis may take into account other factors during the analysis, such as available investments, collateral property, income or cash on hand.

Risk Assessments for Business

Business risks run a large cross-section including, but not limited to: new competitors entering the market, employee theft, data breaches, product recalls, operational, strategic and financial risks, and even natural disaster risks. Every business should have a process in place to assess its current risk levels and put in place procedures to mitigate the worst possible risks.

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