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5 Types of Financial Risks and How to Avoid Them

Common financial actions such as buying a house or investing in the stock market could be considered calculated risks that many people are familiar with. While these might be common instances of financial risks people are willing to take with careful planning involved, not everyone is comfortable with risky behavior. According to one study, just over 72% of adults in the U.S. prefer to reduce risk in an effort to promote stability.

However, risk is an inevitable part of doing business. Understanding how to manage risks before they become unsustainable is of utmost importance to the success of any business or individual. As financial organizations are in the business of mitigating financial risks, they understand this better than anyone.

The ability to identify and curb risk is some of what this article will explore. From common finance problems to basic finance tips, we’ll go over five of the most common types of financial risks and how organizations and individuals can avoid them.

Let’s dive in with a common financial risk type: credit risk.

1. Credit Risk

When a debtor undertakes a loan, whether it be an equipment loan or a personal line of credit, they are undertaking a certain amount of risk. That risk being whether or not they’ll be able to fulfill the obligations of the loan as set forth by a lender. For lenders, credit risk relates to whether or not a borrower will be able to fulfill the terms of a loan.

Bankruptcy, high-interest rates, and defaulted payments are all possible byproducts of poorly managed financials. Defaulted obligations cause harm to borrowers and lenders alike and can lead to huge financial losses depending on the obligation in question.

2. Operational Risk

Operational risk can be difficult to measure. As it relates to the finance sector, operational risk deals with loss that disrupts the flow of financial services and overall business operations. These losses might happen due to poor employee training, poor policy enforcement, and poor system security, to name a few.

However, issues can be tracked with proper historical filing and oversight on behalf of the financial institution or individual.

Improperly managed operating systems and processes are generally what lead to financial risks such as fraud, cybercrime, revenue loss, and more. Financial institutions that have proper operational management in place will be able to better handle any internal and external challenges that arise as a part of handling complex financial issues.

3. Liquidity Risk

The inability to meet short-term financial debt obligations is known as liquidity risk.

Having enough cash flow is crucial to the success of any business or any individual. Liquidity risk is the risk an organization runs that it may not have enough cash flow to pay off existing debts. In addition, this is true for any individual that cannot pay off existing debts as well.

The level of risk an organization faces can be measured by liquidity ratios, which help determine a debtor’s ability to pay back existing loans.

4. Stock Market Risk

Stock market risk, or simply market risk, covers the possibility that investors face vis-à-vis the overall performance of the stock market. While the stock market does go through its own volatile periods, it’s important to know that market risk can be mitigated through diversification of assets.

Many factors come into play when looking at what causes the market to shift:

  • Inflation
  • War or conflict
  • Natural disasters
  • Government policy
  • Federal regulations
  • Changes in technology
  • Publication of the Consumer Confidence Index

The stock market is a complex ecosystem made up of many different types of investors. Knowing that timing, volatility, and overconfidence can swing the pendulum one way or the other helps when it comes to mitigating overall financial gains and losses.

5. Reputational Risk

One could argue that our current economic system is built on a competitive landscape. There are countless financial organizations competing to gain loyal customers. In terms of financial organizations, reputational risk is equally as daunting as any of the four risks outlined above.

From unhappy customers to the tinge of class-action lawsuits, lenders face a number of challenges when it comes to providing financial services, these days. Brand reputation is of utmost importance. Many borrowers don’t care to do business with organizations that have poor reputations when it comes to handling customer finances. Poor reputation leads to a loss of a customer base, which ultimately leads to a loss of revenue.

How To Avoid Financial Risks

So, when it comes to finance mistakes, how can borrowers and lenders alike avoid them? This is a nuanced topic worthy of more in-depth exploration and based on your personal risk profile, but a few key factors can help:

  • Diversify your assets
  • Carry proper insurance
  • Maintain adequate liquidity
  • Recruit the help of a fiduciary advisor
  • Maintain a solid business plan
  • Review organizational processes and procedures

Importance of Mitigating Financial Risks

From small credit unions to large corporate banks and everything in between, financial service providers are in the business of mitigating risk. To stay current and stay on top of common financial risks, it’s important for consumers and lenders alike to understand the types of financial risks that exist.

Having a good understanding of the many different types of risks involved can help both borrowers and financial organizations to continue doing good business.

Interested in More Finance Tips?

Financial success can be a risky business. Knowing the inherent financial risks that come with doing business can help companies, as well as individuals, experience success on their financial journey.

Anticipating, planning, and executing based on good financial models can make all the difference when it comes to growing your wealth. At Morton Brown, we aim to provide a collaborative partnership that helps you better manage your wealth and take care of all of your financial goals.

Our advisors can help guide you through your own personal risk tolerance path. We’re here to help understand and define your risk parameters to build your long-term success. Why not contact us today to see how we can help?