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12. What is Financial Risk

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In this lesson, we briefly talked about the difference between risks and rewards. We learned that the 10 year Federal Note is a risk free investment that provides a marginal return. We know that in follow on lessons, we’re going to use the 10 year note as our baseline value to relatively compare the value of other investments.
When we assess the amount of risk that’s associated with an investment, we learned about three factors that make an investment risky.
1. Debt. We learned that as a company increases the amount of debt (or leverage) they use, it typically results in diminishing returns. By avoiding investments that carry a lot of debt, you’ll mitigate the risks associated with any investment.
2. Price. Although investors might have the opportunity to purchase a really great business, we learned that the price at which they purchase the asset can actually result in a poor investment. We know that the price is what we pay and that value is what we get. This idea is at the heart of a value based investing approach.
3. Knowledge. One of the hardest things for an investor to do is to admit that they don’t know all the facts. Although this may prove challenging, the faster an investor can identify they lack of knowledge or ability to properly account for all the variables, the less risk they’ll assume in any investment.

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