The Many Faces of Risk, Part 2

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. Diversification among asset classes may reduce marketwide or so-called systematic risk. In 2008, the bond market held up just fine 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.

You may also want to consider diversification within one asset class. Holding several stocks (as opposed to just one) from the same industry and other industries may reduce company-specific risk (such as product-launch failure) and sector-specific risk (such as e-books and e-mail taking a bite out of paper company profits). Another way to manage fundamental risk is to invest in companies that have sustainable competitive advantages.

Dollar-cost averaging, or putting your money to work in smaller chunks over time, may reduce 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 potentially 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.

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 between 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.

There is no guarantee that diversification, asset allocation and dollar-cost averaging will protect against market risk. These investment strategies do not ensure a profit or protect against loss in a declining market. In addition, since investing by dollar-cost averaging involves continuous investment in securities regardless of fluctuating prices, investors should consider their financial ability to continue purchases through periods of both low and high price levels.

Returns and principal invested in stocks are not guaranteed, and stocks have been more volatile than bonds. Investing does not ensure a profitable outcome and always involves risk of loss.