The Risk Spectrum
Plain English
There isn't just one kind of financial risk. Even "safe" choices like cash carry a risk (inflation eating your purchasing power) — the question is which risks you're taking, not whether you're taking any.
What is it?
Financial risk comes in several distinct categories: market risk (asset prices fluctuate), inflation risk (purchasing power erodes), interest-rate risk (bond and loan values move with rates), liquidity risk (an asset can't be sold quickly without a discount), longevity risk (outliving your money), and credit/counterparty risk (the other party to a contract fails to perform).
Why does it matter?
Every financial choice trades one risk for another rather than eliminating risk entirely. Holding all cash trades market risk for inflation risk; holding an illiquid investment trades volatility for liquidity risk. Naming the specific risk you're taking is the first step to deciding if it's the right one for your situation.
How does it work?
Different financial products and strategies are essentially different combinations of these risk exposures. Diversification (see the next lesson) mainly addresses market and concentration risk; it doesn't eliminate inflation, longevity, or liquidity risk.
Risks and limitations
No single number fully captures a strategy's total risk — reducing risk to one metric (like volatility alone) can hide risks like longevity or liquidity risk that don't show up in that number.
Questions to ask a professional
Which of these risks does this specific product or strategy address, and which ones does it leave me exposed to? What's the tradeoff I'm making?