In the investment world, "risk" can be summarized as the fluctuation (up and down) in the return on your investment, and not the possibility that you will lose all your savings in one fell swoop. Risk is not an "either-or" proposition, with investments neatly divided into "safe" and "risky" categories. In fact, there are many levels of risk, and while some investments may be "safe" in the sense that they won't actually decline in value, no investment is 100% safe. A smart investor understands the need to undertake a certain amount of risk. If you want higher potential returns, you've got to accept a greater amount of fluctuation. In most cases, riding out these fluctuations will work for you in the long run. Investment risk rarely means total, irretrievable loss.
The amount of risk you take is a personal decision that depends to a certain extent on how strong your nerves are. Investments are by nature unpredictable and even the best investment doesn’t go straight up. If you take on a lot of risk, you have to be prepared to wait out slumps in your share prices.
You can't avoid risk entirely, or try to outsmart it through what you think are cleverly timed purchases and sales. But you can shape your investments to minimize risk and maximize potential return. More on that later.
When thinking about risk, resist all urges to associate investing in the stock market with gambling at a casino. A casino has an interest in seeing you lose your bets - that's how they make money. The stock and bond markets are not about gambling.
The vast majority of investors buy stock in a company because they believe in that company's future; companies that issue stock have an interest in making sure their investors make money.
Of course it doesn't always work that way. Even the best companies go through hard times, and their stock prices reflect that. If a stock's price has grown at an average rate of 12% annually over a ten-year period, that doesn't mean it earned an even 12% per year. Some years it would have done better, some worse. Some years, it may have lost money. You might predict that on average the stock will return somewhere around 12% per year over the next ten years. Just don't expect that exact return for any one given year. Investment risk is measured by determining the amount that actual return deviates from the expected rate of return.
The most commonly used measure to calculate risk is the standard deviation. It is the "typical" deviation from the average return. Two-thirds of the time (precisely 68%), a return will be within one standard deviation of the average.
Consider our old friend the Standard & Poor's 500 Index. The stocks in the S&P 500 have an annual return of about 10% with a standard deviation of about 20%. So roughly 68% of the time, results will probably fall between -10% and +30%. The other 32% of the time, returns will fall outside this average. About 95% of all returns, however, will fall within two standard deviations. Thus, 95% of the S&P 500's returns will likely fall within a range of -30% (10% minus 20% minus 20%) and +50% (10% plus 20% plus 20%).
Of course, that means 5% of the time (one out of 20 years); we will have a return less than -30% or greater than +50%. For example, in 1933 the S&P 500 reported returns of +54%, and in 1954 an impressive +53%. Conversely, in 1931, the S&P returns were a dismal -43%, and in 1937 a nearly as dismal -35%. But no matter how far out short-term returns get, long-term market returns generally return more or less to the mean. Long-term, the S&P 500 has offered a pretty dependable 10% return, even though it has gone through spectacular highs and abysmal lows in the short term.
A smaller variation around the expected result equals a smaller standard deviation, and thus a smaller risk. This variation -- not the risk of losing all your investment -- is what we mean when we speak about risk. Even "safe" investments like CDs and treasury bonds have a measurable risk, since their return does vary. As you might guess, smaller deviation is generally associated with lower returns.
If you look at stock market returns over time, you will see substantial deviation in the short term, with a strong upward trend over time. Market returns are fairly constant over long periods of time, while deviations are short-term. This is why long-term investing can greatly reduce risk.
If an investment declines in value, there is usually a good reason. Certain factors, more than any others, contribute to such declines. These factors are essentially the same ones that can make an investment perform well. Here are some of them:
Business Risk - A company may fall on hard times, negatively affecting stock prices and potentially causing bond defaults. In the worst case, the company could go out of business, leaving the stock or bond you hold worthless.
Market Risk - No matter how well a company is doing, its stock price can be adversely affected by a general decline in the stock market. "Don't fight the tape" is an old Wall Street adage. It refers to the ticker tape (long ribbons of paper) that was used for printing out stock transactions before the electronic age made it obsolete. What it means is, you can't go against the trend of the market.
Interest Rate Risk - If you want to trade a bond (sell it before its maturity date), you will find that its price will have gone down if interest rates have gone up. This is because an older bond paying a lower rate of interest is less attractive than a newer one that pays a higher rate. The lower-interest bond has to be discounted (reduced in price) in order to interest buyers. Higher interest rates also tend to negatively affect stock prices, because they increase costs for companies (such as paying for bank loans) and thus affect their balance sheet. If interest rates go down the effect tends to be positive.
Inflation Risk - This is the risk that your investment may not keep pace with inflation. If your investment is growing at less than the 3-4% average rate of inflation, you will end up poorer in actual buying power.
Currency Risk - Foreign holdings are affected by changes in the exchange rate between currencies. Changes in the exchange rate may be good or bad for your investment, but they are unpredictable. It is not only direct investments overseas that are affected by exchange rate risk. A few years ago, a large U.S. computer manufacturer incurred losses from currency trading that exceeded all of its operating profit.
Political Risk - Actions taken by the U.S. government for political reasons could put a damper on the economy and affect investments. These include raising taxes, imposing a minimum wage or cutting spending. Overseas investments can be hit by serious political upheavals such as revolution, war and confiscation of property in foreign countries. Stocks of U.S. companies with investments overseas may also be adversely affected by political events.
Nobody wants to be subjected to an undue level of risk. The most effective ways to reduce your degree of risk are to have an adequate amount of diversification, build an intelligent asset allocation, and invest in the appropriate assets for your time horizon.
Diversification
If you have your entire account in one stock and its value falls, the value of your entire account will decline by exactly as much as the stock fell. If you are equally diversified across two stocks and one declines, you will only have a 50% exposure to that loss. With three stocks, your exposure goes down to 33.3%. And so on. This dramatic reduction in risk continues until you reach a point of between 20 and 30 stocks. The goal is to become diversified enough to enjoy the upside benefits of good investing while minimizing your downside risk exposure.
Asset Allocation
There are also ways to make the most of a diversified account. You can invest in a range of securities that have different levels of standard deviation (risk). You can choose stocks from different industries. But the most important thing you can do is to diversify across asset classes (invest in different types of assets). This is called asset allocation. One of the strengths of smart asset allocation is that it allows you to invest in securities with a strong low correlation. This means that one investment will zig while the other zags, so that you can be pretty sure you'll always have some investment doing well. In the "Asset Allocation" chapter you'll learn how to choose investments with low correlation, and how these can add value to your total account.
Time Horizon
The most important factor to consider when trying to calculate risk is your time horizon -- how long you can leave your investment without touching it. If you are investing for the long haul, you can most likely afford to include more risk in your portfolio. If you are making a short-term investment, however, you probably want to build a less risky portfolio. Either way, the key is to develop a portfolio whose degree of risk is appropriate for your needs. Bear in mind two critical rules about time horizon:
- Market risk is usually short-term.
- The longer your time horizon, the more risk you can most likely afford to take
