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They say that no investment is without any risk. Money brings the evil of risk with it. If you keep in cash it gets eroded through inflation, if you keep in a fixed deposit, you are exposing yourself to the risk of a bank default, a la BCCI. If you invest in debt or equity, the risk is even more as your returns are then dependent on the company's performance. Plus there are a multitude of factors which affect the risk environment of your investment. The investments are impacted by the micro and macro factors, they work synergistically and the combined domino effect can be devastating. So, truly there are no free lunches.

Then how do you judge the risk profile of your investments, so as to best hedge them or protect them? The place to start is by dividing the factors in macro and micro-Macro being, the broad, outer environment factors, which are out of the control of the company or institution that you have invested in. this could be government policy on interest rates, inflation, wars etc. The micro level factors have to do with the performance and environment of the company or institution itself. For example the industry profile your company operates in, the management quality, the work force quality etc.

Traditionally investment managers try to classify these risks into different categories for better understanding. Some of these categories are:

Economic Risk: The prices of securities may fluctuate because the expectation about the national economy, whether the economy as a whole is slowing or growing. It also means how an economy is doing compared to other competing economies.

Market risk:The possibility that the stock or bond markets will decline over short or extended periods.  The stock market tends to be cyclical, with periods when stock prices generally rise and periods when stock prices generally decline. Bond prices are linked to prevailing interest rates in the economy. As interest rates rise, bond prices fall. Conversely, when rates fall, bond prices rise. The price of a security may also be affected because of the overall sentiment in the market. Sentiment means how most people in the market feel.

Inflation Risk: The possibility that you may not earn enough on your money to keep up with inflation and preserve the purchasing power of your savings.

Interest Rate Risk: Changes in interest rate (which occur due to change in supply and demand for money) influence security prices. In case of fixed income securities, the impact is direct. If interest rate rises, price falls and vice-a-versa. Fall in interest rates may benefit share prices because cost of funds to companies may move down, hence their profit may go up.

Credit Risk: The risk of failure on part of a borrower to meet interest and principal amount obligations.

Regulatory risk: Pries of securities may be affected due to changes in law, procedures, import export policy etc.

Industry risk: A particular industry may be affected due to certain developments peculiar to that industry.

Technology Risk: Discovery of new processes or radical change in technology used by certain companies may affect prices of shares of that company. This is also known as risk of obsolescence.

Environmental Risk: Certain companies may be adversely affected because of certain restrictions imposed on them by the authorities for protection of the environment.

Event Risk: Some times an event such as an accident or an earthquake may influence prices of securities because the event may cripple the operations of a company temporarily or permanently.

Country risk: A country in financial difficulty may impose restrictions on trade and capital flows affecting investments made in that country.

Management risk: An intangible but very important risk which deals with the quality of the management at the helm which steers the future performance of the company. This deals with the vision, morals, conduct and policies of the management.

As you can fathom, from the above definitions of the types of risk, there are some risks which can be diversified or controlled, and there are some which cannot be controlled or diversified. For example you can choose to invest in a company where the management is of top quality, but in event of a sudden change in government policy affecting the business of the company, you will not be able to anticipate and therefore diversify that risk. However well diversified, an investor cannot escape two types of risks- Market Risk and the Inflation Risk. Given that some degree of investment risk is unavoidable, the investor's goal becomes maintaining and ultimately increasing the returns on his or her investments, while managing the risks.

The investment managers then, like insurance companies, seek to cover themselves for various risks that they have identified. This they do by spreading the investments across various assets. For example the risk associated with bank deposits and cash is the least, as a result the returns on them are also the lowest. Next come government paper and bonds of institutions and private companies. These are slightly higher up in the risk ladder and so the returns are also commensurately higher. Stocks of course are at the top of the ladder because you are exposing yourself to macro and micro factors and so the returns are the highest.

There are two main methods of dealing with risk-asset allocation and diversification. On the surface, asset allocation may sound very similar to diversification. Indeed, the principles are related. Both are designed to reduce the risk in an investor's portfolio. At its most basic, diversification means spreading one's money among several different investments. By diversifying into a variety of alternatives, the investor can mitigate the chances of suffering a catastrophic financial loss should one of the investments perform poorly. Asset allocation takes this principle one step further. Asset allocation means diversifying a portfolio not just among different investments but among different investment classes: stocks, fixed income alternatives such as bonds, cash equivalents, and real estate and other tangible assets.

Studies have found that, over the long run, how one's investments are allocated is more important than the individual investments are, in determining overall performance for diversified portfolios. It's not necessarily the specific investments chosen for a portfolio; it's the way those investments are allocated that may make the difference in reaching a financial goal. Furthermore, the process of selecting an appropriate investment mix forces individuals to organize their investments and take into consideration their particular financial needs, risk tolerance, and external factors such as inflation, taxes, interest rates and the current economy.

The first step in asset allocation is to organize the individual's assets into four basic categories: Stocks, Fixed income, Cash equivalents, and Real estate and other tangible assets. The next step is to create an asset allocation model designed specifically to meet the individual needs. Once a specific asset allocation model has been created and implemented, quarterly reviews are a must to see that the investment portfolio is on track and if not then what restructuring is needed.

So even if you have a conservative portfolio, don't go to sleep on it. Be active, analyze the risks every half year or quarter and make the necessary changes.

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