When working with money, you will encounter financial risk. Risk can be managed in four ways:
- Risk Avoidance - To avoid risk, you must refrain from activities which contain risk. For example, if you don't want the risk of losing money, then don't invest in something which may fall in value
- Risk Transference - The best example of this is insurance. A home owner pays an annual fee to an insurance company for home and contents cover. In exchange the company accepts their financial risk. The customer is willing to pay a small amount in exchange for removing the risk of severe financial losses in the event that their assets are lost or damaged..
- Risk Acceptance - Everyone is willing to accept some risk, the amount of risk we are willing to take on is known as our 'risk tolerance level'. Investors will structure their portfolios in accordance with their own risk tolerance level
- Risk Reduction - This involves taking steps to partially offset risks. Installing a sprinkler system will not remove the risk of a building catching fire, but it will reduce the damage by providing water as soon as a fire is detected. A common form of risk reduction in investments, is through diversification.