Risk, it seems, is a four-letter word.
That's true in the literal sense, of course. But it's also no stretch to say risk carries a negative connotation for investors. True, the bull market is still clipping along in 2014 (the S&P is up more than 10%, year to date, on the heels of a 32% gain in 2013 and a 16% increase in 2012), but it stumbled badly (and quickly) from mid-September to mid-October. During that time, the S&P swiftly shed more than 6% as worries mounted about global growth, rudely reminding investors of how volatile the market can be when sentiment shifts--especially when stocks are fully valued.
But there is more to risk than market volatility, and trying to avoid risk is like trying to avoid the oxygen in the room. Risk is a fact of life. Yes, it can punish--sometimes severely. But risk also can reward, sometimes generously if managed well, with patience and perspective.
The point with risk is not to avoid it (because you can't). But neither do you have to submit to it. The point with risk is to take it: Actively take it. Deliberately take it. Take it with purpose, in the right balance and for the right reasons.
Pick Your Poison.
Risk is ever-present. You might think you're avoiding risk by sticking with safer (that is, less volatile) investments, such as bonds. But when you make moves like this, you're usually just swapping one kind of risk for another. In this case, you may have reduced short-term volatility risk, but you likely increased long-term shortfall risk: With a heavy emphasis on lower-yielding "safe" investments, your portfolio may not grow enough to meet your retirement needs or overcome inflation over the long term.
On the flip side, we may also mistake an upward trend in the market for the absence of risk. A strong performance streak doesn't mean there was no risk. It just means that risk didn't bite hard during that time period. Don't confuse being lucky with being risk-proof.
So, we can't avoid risk. But neither should we be oblivious to it. What we need to do is understand the risks we're taking, and remember risk's traveling companion: reward. This keys in on an important point: Risk isn't inherently bad. When you take risk, you can have good outcomes, too. Risks should have related and commensurate potential rewards.
We invest in the market not because risk is bad and we expect to lose money, but because taking risk can be profitable. So, the question is not whether to take risk. Instead, it's what risks do you want to take, and how much?
The Many Faces of Risk.
As suggested above, there is more than one kind of risk, and to manage risk well, you need to consider the different types. For instance, investing risk is not all (or even mostly) about the market's volatility (the Dow's daily ups and downs on Fed talk, China's latest data, or any number of global worries).
When thinking about investment risk, you need to consider company fundamentals (what will cause this firm to succeed or fail), because that will ultimately drive the stock price over time.
There is also price risk. Even if the company is poised for tremendous success, how much are you paying to own a piece of it? If you overpay, you can still lose money, because stocks tend to revert to their fair value over time, even if they occasionally become under- or overvalued.
You also have to consider your own shortfall risk. Conceivably, you're investing in the market to fund some future expense (for instance, college or retirement). If you take money out of the market, or move money from stocks to bonds, what does that mean for your long-term earning potential, given the types of returns bonds tend to produce over long periods of time? Remember, funding that future expense is your primary objective, not avoiding every little dip in the market along the way.
But instead of fundamental, price, and shortfall risk, we investors tend to focus on short-term volatility because that's the thing we see every day, in real time. It's the most apparent and seemingly uncontrollable risk. Make no mistake, volatility may reflect real changes in a company's fundamentals, and that can mean a real loss of money for you. But volatility is often just noise, reflecting worries that won't have any lasting or appreciable effect on a company's operations. In these cases, we shouldn't let volatility risk leave the realm of paper losses.
That's easier said than done, of course, especially during a market crisis or correction. But one way of getting around that is by considering another type of risk: liquidity risk. That's the risk that you can't sell an asset (or at least can't sell it for a reasonable price) when you need to sell it. The upshot: If you have a short-term need for cash, then have cash on hand. That allows you to ride through the volatility risk of your other assets. But remember, if you keep too much cash on hand, you might be raising your shortfall risk. Again, to balance risk well, you need to consider the different types and their trade-offs.
Risk Tolerance vs Risk Capacity.
In order to take risks optimally, we also have to step back and be, well, a little less human and a little more coldly calculating. We need to focus on our real long-term risks and think about how much short-term risk we can actually take (known as our "risk capacity," which is usually dictated by our time horizon, or the amount of time until we need to spend our money). Our risk capacity is not necessarily the same as how much short-term risk we are comfortable taking (our so-called "risk tolerance"). This distinction is vitally important.
If I don't need this money for the next 20 years, I can actually take much more short-term risk with it (in exchange for a potentially higher return) than I can with the money I need to pay the electric bill next week. Just because I have a long time horizon doesn't mean I have to take on a lot of extra short-term risk. If I can be reasonably certain of funding my future expense without that extra risk, I might not want to take it. But for most investors, the opposite is true. Their need for long-term growth necessitates putting money to work in the market, even if their stomachs don't like it.
But the best antacid for investors is to keep their eye on the real goal. If something is going to keep you up at night, not addressing your real, long-term risks (namely, shortfall risk) should be that thing--not what the market did today or might do in December, or next year.
The Risks You Do Take Are Manageable.
The good news is, even if you have to take some short-term risks you'd rather not, you can take the edge off in a number of ways.
Worried about another crisis rocking the stock market? Diversification among asset classes reduces marketwide or so-called systematic risk. In 2008, the bond market held up just fine (the Barclays U.S. Aggregate Bond Index returned more than 5% that year), even though stocks uniformly fell on their face. Holding assets that move in different directions at the same time makes for a smoother ride overall and gives you more options should you need to liquidate a portion of your holdings for some reason.
Worried about one company going bankrupt or losing its edge in the market (in other words, fundamental risk)? Then don't buy just one stock. Diversifying your portfolio with several other stocks from the same industry and other industries can reduce company-specific risk (such as product-launch failure) and sector-specific risk (such as ebooks and email taking a bite out of paper company profits). Another way to manage fundamental risk is to invest in wide-moat companies, or those that have sustainable competitive advantages. These firms are just fundamentally stronger due to certain recognizable advantages. The Morningstar Economic Moat Rating can help you find them.
Worried about putting all your money in the market at exactly the wrong time? Dollar-cost averaging, or putting your money to work in smaller chunks over time, reduces that risk. It also happens to be the de facto way that most people end up investing--with a little bit of money coming out of every paycheck.
Another way to reduce price risk is requiring a margin of safety before buying. All else equal, if you like a stock at $50 per share, you should love it at $30. Buying at a discount means you have room for error in your analysis, a buffer in case of an unforeseen complication, or the chance for extra return if everything goes as planned.
The toolbox for investment risk management is not only well-understood, but also well-tested. Morningstar director of personal finance Christine Benz has demonstrated how a well-allocated, systematically rebalanced portfolio of solid mutual funds could have withstood the tech bubble and the 2008 market crises and paid out regular income for a retiree.
Don't Let Risk Take You.
Unlike the familiar risk of going to work for an immediate reward (a paycheck), when it comes to investing, the reward is typically delayed, while the perceived risk (specifically market volatility) is immediate. Because of short-term market gyrations, investors may also feel that they can't control or moderate their investment risk. So, there is a disconnect of perceived high and uncontrollable present risk on one side, and an uncertain future reward on the other. That just doesn't sound like a good trade-off.
But that story is not complete. You also have to think about shortfall risk and the opportunity cost of not investing (in other words, the money you could have made over time but didn't because you weren't invested). You have to think about the cost of inaction, because not taking any action is potentially risky, too, just in a different way.
When you look at it this way, you should realize you can't avoid risk. So, don't let risk just happen to you. Since you'll end up taking risk in one form or another, you might as well take control, and take smart risks. Take risks in a way that you choose, in a form that you manage to reach your goals--knowing the trade-offs and the consequences and the rewards.