Understanding Investment Risk

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Stock investing has risks; how to understand, plan for, and manage risk to protect yourself and build wealth--and the hidden risk all investors must know.

The time-worn image of a cautious saver stuffing handfuls of dollar bills under a mattress is pervasive for a reason. You can even take that further to your odd uncle who buries gold bars in the back yard. Maybe that's not you, but you can understand the temptation. You work so hard for your money that the thought of losing it all makes you sick. Where can you invest your money to give it a chance to grow? chance to grow? How can you protect yourself from losing value?

These questions keep some people out of stocks. No investment is 100% safe. Every investment has risks. Some are obvious but others are subtle. Can you manage them appropriately? Yes!

What are the Top Investment Risks?

Investment risks fall into three categories: losing all of your principal, making smaller returns than you wanted, and missing better opportunities. The first is the most scary, but the last is the most consequential. If you're in the market for decades, the magic of compound interest is your strongest ally. Sub-optimal return will cut down your wealth over time. Dramatically.

Losing all of your principal is the most obvious stock risk. You could buy shares of a Canadian bed and breakfast in Caribou country—and, one summer season of no visitors later, everything is gone. You're left as the shamed owner of worthless stock certificates. The thousand dollars you wanted to turn into ten has become zero.

Protect yourself from principal loss by researching and buying good companies (good companies have reliable and predictable earnings). The unexpected may still happen. Perhaps a natural disaster will disrupt shipping or manufacturing or a new product or service just won't take off. Otherwise, investors just might get antsy about the company and devalue it below its true value. Yet good companies can weather these storms. This can be a great opportunity to buy more of a good stock at a great price.

Earning smaller returns than anticipated is a risk often realized from getting your research wrong (and, often, ignoring a margin of safety). Maybe you've overlooked something. Perhaps you made a silly math error. You may have predicted better success for a new product line that, in retrospect, no one ever would have bought. In this case, you won't make as much profit as you wanted—you might lose money—but you're unlikely to lose it all.

The third risk is more subtle.

Balance Risk and Opportunity in the Market

Missing a great opportunity is the final and most subtle risk of investing, and it's deeply personal.

Your ability to sleep soundly at night helps determine how you allocate your investment dollars. For example, if you have no tolerance for risk, you might buy US Treasuries as investments. They have a terrible return, but unless the US decides to stop paying its bills altogether, you'll always get what you paid out of them. (Don't mistake the political debates over the deficit spending of the US Federal Government with serious attempts not to pay back Treasuries and other debt instruments of the US government. If the latter ever occurs, you will have bigger problems than the rate of return of your investment.)

You probably can tolerate more risk than Treasuries and their sub-one-percent returns. An average six to eight percent return over multiple year periods is often available in a simple index fund. The risks are higher, as the value of the fund may go down and stay down for a couple of years, but the reward over almost any time period you can imagine balances out the risk—so much that it's almost not even a question.

You can even cushion the risk of an underperforming investment by factoring in a margin of safety to account for missing information or other unknowable risks. You need to do a little math to calculate the present value of the stock to calculate the maximum price you want to pay based on the size and stability of the company. If that number is plausible, you may have found a great deal.

The Opportunity Cost of Not Investing

Inaction keeps many potential investors from good opportunities. If you find a great deal—a pearl of great price situation—you want to be able to take advantage of it without hurting your current financial situation. If all of your money is tied up in other investments, you might have to sell them at losses or risk losing out on the amazing investment.

You can control this! If you have a coherent long term plan and you're following it well, it doesn't matter if you miss some opportunities as long as you take advantage of the good and realistic opportunities you truly have. You don't have to make the maximum return possible on every stock you investigate to build wealth. You only have to make good choices on the stocks you actually buy.

With that said, once you've built up some spare money from dividends or profits you've taken, consider whether you should hold back some free cash until the next good opportunity makes itself known. If nothing's a bargain right now, you don't have to have your money invested. You can afford to be patient.

The Hidden Risk All Investors Should Know

Impatience is the most subtle risk of investing is impatience. Building wealth takes time and care. You won't double your money overnight, not in any reliable or repeatable way. Don't confuse action for effect. To become a millionaire in a week, win the lottery. To build real wealth through investing, spend years cultivating good habits and letting compound interest work for you.

By all means, keep some free cash set aside for that once in a lifetime opportunity you'll always regret passing up, but let yourself be patient. You don't have to make money on every possible bargain, as long as the bargains you find are good ones. It takes time to find great stocks to buy and to figure out their stories. It takes time for the market to find the right price for a stock.

Investing doesn't have to be stressful. It can even be enjoyable, if you set realistic goals based on your appetite for risk and make thoughtful choices.

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