Risk analysis is necessary for those who participate in the stock market to avoid losing massive amounts of money in one deal, but what is it and how does it work? This basic overview can help you understand why financial risk analysis is a critical component of almost all financial decisions.
What is Risk Analysis?
Risk analysis is the studying of uncertainty in the course of an action. Financial risk analysis is when the uncertainty of forecasted future cash flow streams, the variance of portfolio/stock returns, statistical analysis to determine the probability of a project's success or failure, and possible future economic states are looked at closely. Put simply: professionals attempt to forecast the amount of risk for an investor before they spend money on an asset or security to determine if it will result in profits or if there is a high chance of loss.
How Does Financial Risk Analysis Help Stocks?
The stock market has low-risk and high-risk investments, but no investment opportunity comes with zero financial risk. This is why there’s a financial risk analysis for the stock market to determine whether investors can succeed in the future.
There are two basic types of financial risk analysis for stocks: fundamental and technical analysis. Fundamental analysis concentrates on data from sources including financial records, economic reports, company assets and market share. Technical analysis focuses on the study of past market action to predict future price movement.
What is Ex-Post Risk?
Risk analysis also considers a type of risk measurement called "ex-post risk." This technique takes the historical returns of an investment to predict the financial risk in the future. It's the equivalent of the statistical variance of an asset's returns relative to its mean. Ex-post risk has been the most traditional way that investors determine the riskiness of an asset. It's often used as a tool used to give investors the best estimate of the maximum amount of loss that they should expect during the trading day.
How Does Risk Analysis Work?
Financial risk analysts have many different methods they use to determine the riskiness and potential cash flow of an asset. Three of the most common include sensitivity analysis, scenario analysis, and Monte Carlo simulation.
A sensitivity analysis is how different values of an independent variable impact a particular dependent variable under a given set of assumptions. Many companies do a sensitivity analysis to get a better sense of the overall risk of the project the company is about to take.
Scenario analysis is when experts take a particular situation into account to look at the probability distribution of the variables. It takes sensitivity analysis a step further and attempts to get a better view of the outcomes of actions. This is one of the most common financial risk analysis techniques used.
Monte Carlo simulation is sometimes considered to be the "best" method of sensitivity analysis because it comes up with infinite calculations and produces random variables of inputs. From there, the risk analysis is computed.