|Course 103: How Much Risk Can You Tolerate?|
|Contributors to Volatility|
The main way to reduce day-to-day and week-to-week volatility is to diversify your portfolio across different types of securities. By putting together varying investment types, you can reduce the impact of any one of risk factor and therefore limit your short-term volatility.
Market risk. Market risk comes with exposure to a particular asset class or sector, such as U.S. equities or emerging markets bonds. It's the threat that the entire market segment will lose value. For example, U.S. stocks might slump if investors think that the U.S. stock market has climbed too high given slowing economic growth. Alternatively, emerging markets bonds may slump in value because investors expect that inflation will jump up, prompting interest rates to rise. (Rising interest rates tend to be bad news for bonds.)
To limit market risk, diversify into various markets and sectors that will behave differently under different economic scenarios. By doing so, you're reducing your portfolio's dependence on a single market segment. For example, high-quality U.S. bonds generally perform well when investors are feeling fearful about the health of the economy, so they’re a good counterbalance to stocks. In a similar vein, high-yielding securities (such as utilities stocks and real-estate investment trusts), generally perform poorly when interest rates rise; balance those investments with low- or no-yielding choices.
Company-specific risks. Operating risk and price risk are two factors contributing to short-term volatility of individual stocks.
Operating risk is the risk to the company as a business and includes anything that might adversely affect the firm's profitability. Price risk, meanwhile, has more to do with the company's stock than with its business: How expensive is the stock when you consider the company's earnings, cash flow, or sales?
To limit company-specific risk, own a collection of stocks rather than just a few. Owning mutual funds, which are diversified baskets of investments, helps mitigate company-specific risks.
Country risk. Whether you invest only in U.S. stocks or put some dollars outside the U.S. market, you're exposing your portfolio to the risks of investing in that country. There's political risk, or the risk that the current leadership will change for the worse, as well as the threat that economic conditions in that country could make it hard for companies to grow. And if you’re investing in securities denominated in a currency other than your home currency, as is the case when you invest in most foreign-stock mutual funds, there’s a chance that the foreign currency could lose strength versus your home country’s currency.
To limit country risk, do one of two things. If you own both U.S. and foreign securities, invest in a variety of markets, not just a few. If you invest strictly in U.S. securities, be sure your investments aren't overly reliant on just the U.S. for their success. For example, make sure some of your companies have expanded internationally, even though they’re headquartered in the U.S. They'll probably be more resilient than less-diverse companies when the U.S. economy slows.
Next: How Much Volatility Can You Take? >>
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