What is Risk Assessment

Risk assessment is a general term used across many industries to determine the likelihood of loss on an asset, loan, or investment. Assessing risk is essential for determining how worthwhile an investment is and the best process(es) to mitigate risk. It presents the upside reward compared to the risk profile. It also determines the rate of return 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 often by mortgage lenders to evaluate the risk of lending funds; and credit analysis, used by lenders to determine the creditworthiness of the borrower.

Risk Assessments for Investments

Both institutional and individual investments have expected amounts of risk. This is especially true of non-guaranteed investments, such as stocks, bonds, mutual funds, and exchange-traded funds (ETFs). 

Standard deviation measures the dispersion ratio around a central tendency; it is essentially how much plus or negative movement can be expected from a central statistic. As of May 2016, the Standard & Poor's (S&P) 500 Stock Index, represented by the SPDR S&P 500 ETF (NYSE: SPY), presented a three-year return of 11.14% and a standard deviation of 11.32%. Although the fund returned 11.14% return over the entire period, its variation within the period could have represented a return of -0.18% or of 22.46% seventy percent 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, known as credit checks. For example, it is common that lenders do not approve borrowers who have credit scores below 600 because lower scores are indicative of poor credit practices. A lender's credit analysis may consider other factors, such as available investments, collateral property, income, or cash on hand.

Risk Assessments for Business

Business risks are vast and vary across industries. Such risks include new competitors entering the market, employee theft, data breaches, product recalls, operational, strategic and financial risks, natural disaster risks, et. al. Every business should have a process in place to assess its current risk levels and enforce procedures to mitigate the worst possible risks.