Financial Theory and Investment Decisions
There are many definitions of risk, but the definition I’ve found that most closely aligns with investing and risk management is that risk is the potential for deviation from an expected result, whether the deviation is a positive or negative result. Managing investment risks, by extension, is the analytical process that measures the potential for deviation to better enable decision-making on what risk to pursue, mitigate or avoid. Risk and return go together, and every investment decision carries an element of risk, which is why a practical understanding of financial theory can assist investment decision-making.
Market Risk
There are many risk factors that could give rise to market risk, including: geopolitical risk, monetary and fiscal policy, changes in interest rates and foreign exchange rates, terrorist events, and natural disasters. The need to understand market risk has grown as the operating environment has become more volatile and this volatility has increased the potential for large, frequent and unexpected asset price swings, consequently regulators have increased expectations for banks to develop extreme but plausible scenarios for their modeling framework, but investors also need to consider how volatility catalysts could impact their portfolios, and many brokerage firms have built capabilities that enable investors to stress test their portfolios.