Final answer:
The best practice in allocating risk is to assess potential investments with regard to personal factors like age and goals, with higher risk levels potentially acceptable early in a career. There are two risk categories, systematic and unsystematic, with diversification being an essential strategy to mitigate the latter. Proper risk management and diversification are key practices for managing potential losses and promoting positive returns.
Step-by-step explanation:
The established best practice in allocating risk involves assessing potential investment opportunities by considering various factors such as an individual's age, investment goals, and time horizon. Typically, as one advances through life, their risk tolerance tends to decrease, leading to adjustments in investment strategies. During the early part of one’s career, when there is more time to recover from potential losses, a higher risk level might be acceptable.
There are two general categories of risk: systematic and unsystematic risk. Systematic risk, also known as market risk, affects the entire market and cannot be diversified away. In contrast, unsystematic risk or idiosyncratic risk, is specific to a single company or industry and can be mitigated through a diversified portfolio.
Assessing risk before making an investment includes analyzing the types of financial assets, considering the volatility and the potential returns, as well as the individual's risk tolerance. Diversification is key to reducing unsystematic risk, which is why having a diversified portfolio is important. It spreads out exposure to various assets, industries, and geographical regions, minimizing the impact of a single asset’s poor performance on the overall portfolio’s returns.
It’s important to remember that no investment strategy guarantees economic success, but proper risk management and diversification are essential practices for increasing the potential for positive returns while managing potential losses.