Where the Risk Lies
It is important to understand all the risk you face as an investor. Risk comes in many forms and some risks are higher than others at different stages of market cycles. Understanding the risks that could hurt you the most and how you can offset or reduce that risk is important to your long term success as an investor.
There is company specific risk. That is the risk that you will own a company like Enron or MCI or Kodak or any other of a myriad of companies that have fallen by the wayside. The cure for market risk is broad diversification. If your portfolio had a 1% exposure to Enron when they imploded it didn’t really hurt, the other 99% of your portfolio likely bailed you out. But if Enron was 20% or more of your portfolio it hurt a lot and took a long time to recover from.
There is interest rate risk. That is the risk that interest rates will rise. This is generally bad for dividend paying stocks, but is really, really bad for bonds, as bond prices fall when interest rates increase. I would venture that interest rate risk is higher in most portfolios today than at any time in the last 25 years.
There is inflation risk. The risk that the falling value of a currency will lead to lower purchasing power per unit of currency. Inflation is really bad for bond holder as they are repaid with currency that purchases less goods and services than the currency they originally loaned out. You can offset inflation risk to a degree by investing in inflation protected bonds or by investing in companies that pay dividends that go up over time.
There is political risk. That is risk that an act of the government could adversely affect an industry. Energy policy can mean millions of dollars of extra business for oil companies or millions of dollars of extra business for renewable energy firms. Tax policy can benefit some industries more than others. Political risk is hard to avoid because it changes so often and is so capricious in its implementation. Here, diversification is once again your friend.
Finally, there is obviously, market risk. Which is will the market prices of the securities you own go down in value over some arbitrary time frame. I say some arbitrary period of time because over the long run this risk has always disappeared. Over the last decade, we have seen markets go down by 50% or so, only to see them rebound by more than double that number. In your lifetime, you will likely see over two dozen times when stocks will retreat by at least 15%. Yet over your lifetime the stock market will almost certainly be a one-way street with the bias to the upside. Maybe we should call this the risk of missing out rather than market risk, because the fear of short term dips could prevent you from profiting from the permanent ups of stock ownership.
Understanding the risks you face and the ways you can offset that risk will help you become a better investor. Invest some time to contemplate the risks you are facing today.