| Most people think of stock market risk as the chance | | | | Generally, risk and reward go hand in hand. If you |
| that they will lose money in a particular investment. | | | | take a greater risk, you should intend for a greater |
| Actually, the risk of investing in the stock market falls | | | | reward. You have to be careful though. Sometimes |
| into many categories. "Market risk" is the risk that | | | | you take a very high risk and don't get the |
| the entire market will go down. When that happens, | | | | opportunity for a high reward. If you want a high |
| most of the stocks you own will go down too. The | | | | degree of safety, generally, you should expect a |
| same is true for mutual funds. Buying shares in all | | | | lower rate of return. If you want a very high rate of |
| companies listed on a stock exchange does not | | | | return, and take the risks associated with big returns, |
| eliminate stock market risk. Think about it. Even if | | | | every once in awhile, you should expect to lose big. |
| you invest in "the market", you still have exposure to | | | | We have all heard that stocks are risky in the short |
| the risk that "the market" will fall. The only way to | | | | run but not for the longer term. How is it possible |
| reduce stock market risk is to invest some of your | | | | that short-term stock market risk largely disappears |
| assets outside of the stock market. For instance, | | | | at long horizons? Where does the risk go? The |
| buying bonds is a good way to reduce your | | | | swings in the rate of return that reduce long-term |
| vulnerability to a falling stock market; so is investing in | | | | risk is known as "mean-reversion". It means that |
| real estate or art. | | | | unusually high stock returns today lower the |
| "Concentration risk". If you put all of your money into | | | | expectation of returns in the future. Bull markets |
| the stock of only one company, you leave yourself | | | | tend to be followed by corrections. Bear markets |
| wide open to both stock market risk and | | | | tend to be followed by recoveries. Stock prices |
| company-specific risk because all is riding on one | | | | revert towards a long-run average or mean, and |
| firm's fate. This is especially common for employees | | | | stocks are said to be "mean-reverting". Under these |
| of that one Company. Spreading the same money | | | | circumstances, stock market risk declines as your |
| among, say, twenty different stocks will go a long | | | | investment horizon lengthens because the longer |
| way toward reducing your portfolio's dependence on | | | | your holding period, the closer your return will be to |
| any one of the companies purchased. In other | | | | the average. |
| words, simply owning many companies can | | | | During roaring bull markets, investors are attracted to |
| dramatically reduce company-specific risk. Long | | | | the stock market by the prospect of future high |
| before you and I were born, some wise person said: | | | | returns, greed. They hope to earn high stock returns |
| "Don't put all your eggs in one basket." | | | | in the future similar to the high returns of the past. If |
| There is "event risk" that could affect a specific | | | | instead, stocks mean-revert, future returns are likely |
| company. For example, an article could appear in the | | | | to be lower. During dramatic stock market declines, |
| newspaper that a company's product causes cancer | | | | individual investors allow fear to overtake them and |
| or a plane crash could kill the entire management | | | | they sell their stocks, very often at or near the |
| team. There's "opportunity risk" - that means that | | | | bottom. |
| you could have done something better with your | | | | A major problem here is that you might wait too long |
| money. There's the "risk of inflation". This means that | | | | before getting back in. You would miss out on the |
| your rate of return could have been lower than the | | | | good market that invariably follows the bad market. |
| rate of inflation over a period of years. Even if you | | | | It's even worse, if you allow fear of a bear market |
| made all the correct investment decisions, if the | | | | to keep you from ever investing in the stock market |
| long-term rate of inflation was the same as your | | | | again. If you have a clear understanding of |
| long-term rate of return, basically, you broke even in | | | | stock-market cycles, you might be more comfortable |
| terms of buying power. | | | | investing in bad times. When most things go on sale, |
| "Financial risk" can be divided into two parts. The first | | | | more people to want to buy. Warren Buffett said: |
| part is the probability of the stock declining. The | | | | "The stock market is the only business I know of, |
| second part is the potential magnitude of the decline. | | | | that when there is a sale, nobody comes. |