Understanding Risk (Overview)

What is risk?

In general

Risk is all around us, and we all take risks every day. Some people consider driving a car risky. Others don't seem to mind driving but don't like flying in an airplane--even though statistics show you're far more likely to die in a car than in an airplane. Some of us, like racecar drivers, cliff divers, and bungee jumpers, actually thrive on risk. Others go to great lengths to reduce risk.

Risk is multidimensional with many factors interacting. For example, an athlete in top physical condition may suffer a fatal heart attack while exercising because he or she has a family history of heart disease.

Some risks are more apparent than others. For instance, walking a high wire is quite obviously a risk. On the other hand, the danger of being struck by lightning is not so obvious.

The bottom line is that you can't live without taking some risks. Since you cannot totally eliminate them, the best you can do is try to reduce them as much as possible. That's why we avoid people with colds, eat healthy diets, wear life jackets when we go boating, and buy life insurance.

Risk in the investment world

Some people view risk as a negative, others as a positive. Ask any group of people what risk means to them, and you are likely to get some of these answers:

• Danger
• Possible loss
• Uncertainty
• Challenge
• Opportunity
• Thrill

In the investment world, however, risk means uncertainty. It refers to the possibility that you will lose your investment or that an investment will yield less than its anticipated return. More simply stated, risk refers to the probability that an investment will make or lose money. Every investment carries some degree of risk because its returns are unpredictable. The degree of risk associated with a particular investment is known as its volatility.

The relationship between risk and return

When you invest, you plan to make money on that investment or, more accurately, earn a return. Risk and return are directly related. The higher the risk, the higher the return potential. If you want a higher rate of return, you will have to accept a higher risk. Conversely, you may accept a lower risk, but the return potential is lower.

The relationship between risk and time, or the time horizon

The length of time that you plan to remain in a particular investment vehicle is known as your investment planning time horizon. Generally speaking, the longer your time horizon, the more you can afford to invest more aggressively, in higher-risk investments. This is because the longer you can remain invested, the more time you'll have to ride out fluctuations in the hope of getting a greater reward in the future. Of course, there is no assurance that any investment will not lose money.

Risk-taking propensity

Each of us is able to accept a certain amount of investment risk. This is known as our risk-taking propensity. Those of us who can accept a relatively great amount of risk are referred to as risk tolerant. On the other end of the spectrum, those who can accept very little risk are known as risk averse. Those who hold the middle ground are risk neutral or risk indifferent.

There are ways to measure your risk tolerance, using tests to assess how you react to different types of risk, such as monetary, physical, social, and ethical. These tests aren't foolproof, since we are essentially talking about psychological behaviors that may vary under different conditions. However, the results from these tests are generally considered reliable and valid.

Your risk-taking propensity is as important in determining which investments match your risk-return expectations as the risk of the investment itself.

How do you evaluate the risk of a specific investment?

Before you can evaluate the risk of a specific investment, you must understand the types of risk that exist and how to measure them.

As in your day-to-day life, risks are prevalent in the investment world, and some are more apparent than others. Each investment is subject to all of the general uncertainties associated with that type of investment. These are known as systematic risks and include market, interest rate, and purchasing power risk, among others. Risk also arises from factors and circumstances that are specific to a particular company, industry, or class of investments. These are known as diversifiable or unsystematic risks. Diversifiable risks include business, financial, and default risk, among others.

Measuring risk involves analyzing the different types of risk using an array of mathematical tools and techniques (e.g., the standard deviation, Beta, Alpha, and so forth). The statistics obtained provide an investor with some standardized measurements with which to make an educated decision.

Rating services

You don't need to measure risk yourself. Ratings services, such as Standard & Poor's, Fitch, Moody's, Value Line, and Morningstar, compile and publish risk and return statistics for many types of investments. These services provide an investor with key information and statistics in a condensed and easy-to-read format.

To obtain rating service reports, check with your public library. It may subscribe to some or all of these services. If not, you may have to subscribe yourself, for an annual fee. Some services offer a free trial period.

Research

For specific investments, you may be able to view an annual report, prospectus, or proxy statement with financial information and outlined business strategies. To obtain copies of these documents, contact the issuer of the security.

You may find helpful information in books, newspapers, magazines, journals, newsletters, or on the radio, television, or Internet.

How do you reduce risk?

Diversify

One of the best ways to reduce risk is to develop a portfolio of investments that is balanced in terms of the types of assets in which you invest. In other words, don't put all your eggs in one basket. This is known as diversification or asset allocation. A portfolio that mixes a variety of asset classes (e.g., cash, bonds, domestic and foreign stocks, and real estate) has a lower risk for a given level of return than does a portfolio that consists of only one. Diversification works because it broadens your investment base. It can be achieved by company, industry, type of security, markets, or by investment objective.

How an investor diversifies depends upon his or her own situation. An investor can be aggressive (investing mostly in high-risk vehicles), conservative (investing mostly in low-risk vehicles), or somewhere in between.

Allow for the passage of time

Historically, time has had a dampening effect on the riskiness of investments (though there is no guarantee this will continue in the future). In "investmentspeak," the standard deviation associated with the average rate of return on an investment has decreased with the square root of time. In plain English, the longer the investor remained invested--or the longer the investor's time horizon--the less risky the investment has become.

Do your homework

You may be able to reduce some risk simply by being diligent. For example, have real estate inspected and appraised before you buy it, or investigate a company's financial condition before you purchase stock in it.

Gauge the economy by identifying trends in overall business conditions. These trends are indicated regularly (weekly or monthly) by figures on inventories, prices, employment, and the GDP. Is the economy on an upswing or downswing? Knowing this will help you choose an investment more likely to appreciate under the given conditions.

Choose investments that make sense to you. For example, buy stock in a company with relatively stable earnings, or one whose sales are likely to keep up with inflation, or one whose products are in great demand, or one who sells a product for which the demand is constant, such as food.

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Handling Market Volatility

Conventional wisdom says that what goes up, must come down. But even if you view market volatility as a normal occurrence, it can be tough to handle when it's your money at stake. Though there's no foolproof way to handle the ups and downs of the stock market, the following common sense tips can help.

Don't put your eggs all in one basket

Diversifying your investment portfolio is one of the key ways you can handle market volatility. Because asset classes typically perform differently under different market conditions, spreading your assets across a variety of investments such as stocks, bonds, and cash equivalents (e.g., money market funds, CDs, and other short-term instruments), has the potential to help reduce your overall risk. Ideally, a decline in one type of asset will be balanced out by a gain in another, but diversification can't eliminate the possibility of market loss.

One way to diversify your portfolio is through asset allocation. Asset allocation involves identifying the asset classes that are appropriate for you and allocating a certain percentage of your investment dollars to each class (e.g., 70 percent to stocks, 20 percent to bonds, 10 percent to cash equivalents). An easy way to decide on an appropriate mix of investments is to use a worksheet or an interactive tool that suggests a model or sample allocation based on your investment objectives, risk tolerance level, and investment time horizon.

Focus on the forest, not on the trees

As the market goes up and down, it's easy to become too focused on day-to-day returns. Instead, keep your eyes on your long-term investing goals and your overall portfolio. Although only you can decide how much investment risk you can handle, if you still have years to invest, don't overestimate the effect of short-term price fluctuations on your portfolio.

Look before you leap

When the market goes down and investment losses pile up, you may be tempted to pull out of the stock market altogether and look for less volatile investments. The small returns that typically accompany low-risk investments may seem attractive when more risky investments are posting negative returns.

But before you leap into a different investment strategy, make sure you're doing it for the right reasons. How you choose to invest your money should be consistent with your goals and time horizon.

For instance, putting a larger percentage of your investment dollars into vehicles that offer safety of principal and liquidity (the opportunity to easily access your funds) may be the right strategy for you if your investment goals are short-term (e.g., you'll need the money soon to buy a house) or if you're growing close to reaching a long-term goal such as retirement. But if you still have years to invest, keep in mind that stocks have historically outperformed stable value investments over time, although past performance is no guarantee of future results. If you move most or all of your investment dollars into conservative investments, you've not only locked in any losses you might have, but you've also sacrificed the potential for higher returns.

Look for the silver lining

A down market, like every cloud, has a silver lining. The silver lining of a down market is the opportunity you have to buy shares of stock at lower prices.

One of the ways you can do this is by using dollar cost averaging. With dollar cost averaging, you don't try to "time the market" by buying shares at the moment when the price is lowest. In fact, you don't worry about price at all. Instead, you invest money at regular intervals over time.

When the price is higher, your investment dollars buy fewer shares of stock, but when the price is lower, the same dollar amount will buy you more shares.

For example, let's say that you decided to invest $300 each month towards your child's college education. As the illustration shows, your regular monthly investment of $300 bought more shares when the price was low and fewer shares when the price was high:

Although dollar cost averaging can't guarantee you a profit or avoid a loss, a regular fixed dollar investment may result in a lower average price per share over time, assuming you continue to invest through all types of markets. You should consider your financial ability to make ongoing purchases, regardless of price fluctuations, however.

(This hypothetical example is for illustrative purposes only and does not represent the performance of any particular investment. Actual results will vary.)

Don't stick your head in the sand

While focusing too much on short-term gains or losses is unwise, so is ignoring your investments. You should check up on your portfolio at least once a year, more frequently if the market is particularly volatile or when there have been significant changes in your life. You may need to rebalance your portfolio to bring it back in line with your investment goals and risk tolerance. A financial professional can help you decide which investment options are right for you.

Don't count your chickens before they hatch

As the market recovers from a down cycle, elation quickly sets in. If the upswing lasts long enough, it's easy to believe that investing in the stock market is a sure thing. But, of course, it never is. As many investors have learned the hard way, becoming overly optimistic about investing during the good times can be as detrimental as worrying too much during the bad times. The right approach during all kinds of markets is to be realistic. Have a plan, stick with it, and strike a comfortable balance between risk and return.

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