What is Valuation Risk?

Mary McMahon
Mary McMahon

Valuation risk is the risk that a financial asset is overvalued and will fetch less than expected when it matures or is sold by the person who holds it. Factors contributing to valuation risk can include incomplete data, market instability, and poor data analysis by the people responsible for determining the value of the asset. This risk can be a concern for investors, lenders, and other people involved in the financial industry. Overvalued assets can create losses for their owners.

Man climbing a rope
Man climbing a rope

A number of steps are taken to reduce valuation risk. People tasked with determining fair and reasonable values for assets work to collect as much data as possible in order to have a complete and detailed picture. They also apply a number of data analysis techniques to the exploration of that data with the goal of identifying pitfalls by approaching the valuation from multiple perspectives. Individuals determining whether they want to buy assets may do their own value analysis to see if the stated value reflects the current available information.

Even with steps to avoid obvious problems, people can still be exposed to valuation risk. An investor may decide not to invest in a company that appears to be overvalued, but might still run into trouble by purchasing a bond that doesn't pay out, or being involved in a pooled investment product that does not generate the expected return. The people responsible for managing the asset, such as administrators of a mutual fund, are tasked with limiting valuation risk for their investors, but they cannot control for factors like a sudden economic downturn or the downfall of a company the fund has invested in.

Government regulators supervise the valuation process for things like initial public offerings and bond issues. They use reports generated by companies preparing for such offerings to confirm that the offering is fairly valued and does not expose investors to unreasonable risks. They cannot control for value risk once items are traded on the open market. Investors can drive up the price of a stock to the point where there is a risk of taking a loss by purchasing it or stock values can fall suddenly in response to changing economic conditions.

Investors at all levels are concerned about valuation risk, from individuals making decisions about their retirement portfolios to institutional investors. Careful analysis and research is used to reduce the chances of taking a loss on an asset. For inexperienced investors, financial advisers are available to provide guidance on sound investments.

Mary McMahon
Mary McMahon

Ever since she began contributing to the site several years ago, Mary has embraced the exciting challenge of being a wiseGEEK researcher and writer. Mary has a liberal arts degree from Goddard College and spends her free time reading, cooking, and exploring the great outdoors.

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