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Course 103
How Much Risk Can You Tolerate?

Introduction

Husbands endure Saturday-evening dinners with their in-laws in exchange for a Sunday of uninterrupted football. Kids pass up watching television to take out the trash and wash dishes because they want spending money. And parents extend Friday night curfews as a reward for good behavior during the week.

Life is about trade-offs. So is investing.

The investment trade-off is between risk and return. Getting a return on your investment means accepting risk, at least to some extent. But what, exactly, is risk? And how much of it can you tolerate?

This course will review the types of risk involved in investing, and show you how to develop your philosophy about investment risk.

Two General Risks

Investors face two general types of risk.

First, there's the risk of losing money over the short term. Over the last 85 years, the stock market has returned around 10% per year, on average. However, looking at individual years over that time period, about one out of every four was a down year in the market.

And over shorter time periods--a few weeks or months--investments can be even more volatile.

Investors focus almost exclusively on this type of risk. It's easy to do. Every day you hear about how the market is doing on the radio and television. And if that's not enough, you can check your stock prices throughout the day.

Don't let volatility get the best of you, though. If you do, you'll virtually ignore the second and perhaps even greater risk that comes with investing: the risk that you won't meet your goals.

How can obsessing about volatility get in the way of your goals? It may cause you to invest too conservatively. Volatility also may lead you to buy or sell an investment based on short-term performance rather than on how this purchase or sale will help you reach your goal. In short, volatility can prevent you from seeing the forest for the trees.

Weigh how important reaching your goal is against how much short-term volatility you're willing to accept.

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.

How Much Volatility Can You Take?

Diversifying your portfolio across stocks, bonds, and funds that will behave differently at various points in time can help reduce short-term volatility. It may also help to remember that putting up with day-to-day gyrations in your portfolio is likely to help stave off that biggest risk of all: not having enough money when it comes time to tap your portfolio. By doing that, you’re acknowledging that In the ideal world, your time horizon and your goal would determine how much volatility you'd tolerate.

You're not an emotionless robot who doesn't react to volatility, though. You're human. As such, consider how volatility may interfere with you meeting your goal. Then do whatever you can in your portfolio to thwart the factors that lead to volatility. In other words, limit your risk by diversifying across a variety of markets and companies.

Finally, answer these questions to develop your investment philosophy about volatility and risk.

• How much of a loss can you accept from your portfolio each year?
• How much of a loss can you accept over a five-year period?
• How much risk can you accept from your individual investments?
• How do you plan to diversify your various investment risks (market, company-specific, economic, and country)?
• What risk-related test will an investment have to pass before making it into your portfolio?

Quiz 103
There is only one correct answer to each question.

1 What type of risk do investors overlook most often?
a. Volatility
b. The risk of not meeting their investment goal
c. Market risk
2 Which is NOT a way that volatility can lead you to miss the forest for the trees?
a. Volatility may make you invest too conservatively.
b. Volatility may make you buy or sell an investment based only on short-term performance.
c. Volatility may make you buy or sell a security based on your goals.
3 How can you limit market risk?
a. Invest in a variety of markets.
b. Invest in a variety of stocks.
c. Invest in securities that do well in a recession.
4 How can you limit company-specific risks?
a. Invest in that company's bonds.
b. Invest in a variety of stocks.
c. Invest in securities that do well in a recession.
5 To limit volatility?
a. Diversify.
b. Check your stocks prices daily.
c. Own just a few securities.
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