Most people think of stock market risk as the chance that they will lose money in a particular investment. Actually, the risk of investing in the stock market falls into many categories. “Market risk” is the risk that the entire market will go down. When that happens, most of the stocks you own will go down too. The same is true for mutual funds. Buying shares in all companies listed on a stock exchange does not eliminate stock market risk. Think about it. Even if you invest in “the market”, you still have exposure to the risk that “the market” will fall. The only way to reduce stock market risk is to invest some of your assets outside of the stock market. For instance, buying bonds is a good way to reduce your vulnerability to a falling stock market; so is investing in real estate or art.
“Concentration risk”. If you put all of your money into the stock of only one company, you leave yourself wide open to both stock market risk and company-specific risk because all is riding on one firm’s fate. This is especially common for employees of that one Company. Spreading the same money among, say, twenty different stocks will go a long way toward reducing your portfolio’s dependence on any one of the companies purchased. In other words, simply owning many companies can dramatically reduce company-specific risk. Long before you and I were born, some wise person said: “Don’t put all your eggs in one basket.” We have many more Retirement Investing Help Articles Now Available.
There is “event risk” that could affect a specific company. For example, an article could appear in the newspaper that a company’s product causes cancer or a plane crash could kill the entire management team. There’s “opportunity risk” – that means that you could have done something better with your money. There’s the “risk of inflation”. This means that your rate of return could have been lower than the rate of inflation over a period of years. Even if you made all the correct investment decisions, if the long-term rate of inflation was the same as your long-term rate of return, basically, you broke even in terms of buying power.
“Financial risk” can be divided into two parts. The first part is the probability of the stock declining. The second part is the potential magnitude of the decline. Generally, risk and reward go hand in hand. If you take a greater risk, you should intend for a greater reward. You have to be careful though. Sometimes you take a very high risk and don’t get the opportunity for a high reward. If you want a high degree of safety, generally, you should expect a lower rate of return. If you want a very high rate of return, and take the risks associated with big returns, every once in awhile, you should expect to lose big.
We have all heard that stocks are risky in the short run but not for the longer term. How is it possible that short-term stock market risk largely disappears at long horizons? Where does the risk go? The swings in the rate of return that reduce long-term risk is known as “mean-reversion”. It means that unusually high stock returns today lower the expectation of returns in the future. Bull markets tend to be followed by corrections. Bear markets tend to be followed by recoveries. Stock prices revert towards a long-run average or mean, and stocks are said to be “mean-reverting”. Under these circumstances, stock market risk declines as your investment horizon lengthens because the longer your holding period, the closer your return will be to the average.
During roaring bull markets, investors are attracted to the stock market by the prospect of future high returns, greed. They hope to earn high stock returns in the future similar to the high returns of the past. If instead, stocks mean-revert, future returns are likely to be lower. During dramatic stock market declines, individual investors allow fear to overtake them and they sell their stocks, very often at or near the bottom.
A major problem here is that you might wait too long before getting back in. You would miss out on the good market that invariably follows the bad market. It’s even worse, if you allow fear of a bear market to keep you from ever investing in the stock market again. If you have a clear understanding of stock-market cycles, you might be more comfortable investing in bad times. When most things go on sale, more people to want to buy. Warren Buffett said: “The stock market is the only business I know of, that when there is a sale, nobody comes.” We have many more Retirement Investing Help Articles Now Available.