How to Be Smarter About Risk Management
Investors should only take risks that the market rewards--and that they can live with.
Note: This article is part of Morningstar's November 2014 Risk Management Week special report. An earlier version appeared Aug. 13, 2014.
In isolation, risk is neither good nor bad. Finance 101 teaches that the market must offer higher expected returns as an asset's probability of declining in value or the potential magnitude of losses increases. Otherwise, given the choice between two investments, no one would hold the riskier one. Investors tend to compete away high-return, low-risk opportunities, so that risk is usually the primary source of investment returns. This is why risky asset classes, such as stocks, have historically offered higher returns than Treasuries over the long run. But large drawdowns at inopportune times, coupled with investors' tendency to buy high and sell low, can create a significant challenge for wealth accumulation. Managing risk effectively is one of the most important aspects of successful investing. There are several ways to do this.
Alex Bryan has a position in the following securities mentioned above: USMV. Find out about Morningstar’s editorial policies.