With today's increasingly volatile markets, investors are again examining their risk exposures. During a raging bull market, such as that of the past few years, investors pay little attention to risk because all investments appear to rise in value. Because of fears that the market is still overvalued, there is no better time than now to take a second look at your risk profile.
Most discussion about risk involves the risk versus reward trade-off. This principle implies that the only way to increase your return is to take on more risk. Although true, it is an oversimplification. Just taking more risk does not mean you will get higher returns, because if you knew that you would get a certain reward, you would obviously take the risk.
Because an investor faces numerous types of risk, any discussion about risk quickly becomes very complicated. The main types that the individual investor should be concerned with are inflation risk, concentration risk, credit risk and volatility. For purposes of this discussion, risks that involve broad macroeconomic issues and those that the individual investor cannot control, such as changes in interest rates, are going to be ignored.
One of the main benefits of investing in the stock market is the potential to earn a rate of return greater than the inflation rate. Guaranteed investments that offer very low returns face inflation risk, or the failure to grow your assets at a rate above that of inflation.
For example, if you invest your money in a certificate-of-deposit (CD) that earns 4%, you will actually lose money if inflation reaches 4.5%. Whereas savings accounts and CD's are guaranteed not to decline in value, you are sacrificing additional potential rewards for this low risk investment.
Investors must also be aware of concentration risk. As addressed in the last column, the best way to reduce this risk is to diversify your investments and prevent any one stock or mutual fund from playing a large role in the performance of your portfolio.
Whereas concentration risk is easily avoidable, credit risk is slightly more difficult to protect against. If you are investing in individual stocks, this is the risk that the company will go bankrupt and you will lose all of your money. Most credit risk can be eliminated by making carefully planned investment decisions in sound companies. Professional money managers rarely invest in companies that go bust, though it does happen.
The most type of risk that an investor needs to consider is volatility risk. A highly volatile stock increases and decreases in value very quickly and with great magnitude. If you invest in these kinds of companies, make sure that you have a strong stomach.
Since no two investors are the same, each person must determine his or her own willingness to accept risk. A good test is to look at the following scenarios. Which would you prefer: a $10,000 investment that can either increase to $12,000 or that can decline to $8,000 versus a $10,000 investment that can go up to $11,000 or down to $9,000? The first scenario offers a greater potential return, but it also carries a greater potential downside.
Although every portfolio should be well diversified, the amount of money in each type of investment will be determined by your risk tolerance. Smaller companies and companies in high growth industries, such as technology and healthcare, are typically riskier because they are less stable. Therefore, if you feel comfortable with the added risk, these types of investments should make up a greater percentage of your portfolio.
If you are investing money that you will not need access to for 10 or more years, consider accepting a fair amount of risk. This long time horizon will allow you to let the money remain invested and ride the ups and downs of the market.
The worst thing is to pull money out of a bear market just before the market turns positive out of fear of further declines. You should never accept more risk than you feel comfortable with, yet failure to take on enough risk entails a large opportunity cost.
Eric Weisman is a Trinity senior. This article is not intended to replace the advice of a professional financial adviser. This article is also not intended as a solicitation to buy or sell, nor is the author licensed to do so.
Get The Chronicle straight to your inbox
Signup for our weekly newsletter. Cancel at any time.