Defining Risks in Investing
Risk in investing is the culmination of the fear and uncertainty that a particular investment will not yield a satisfactory return or even worse that the investor will lose the initial capital invested. What is important for investors to keep in mind is that risks come from multiple directions that may or may not relate to the fundamentals of the particular investment. Also, risk is a relative term because individuals have different assessments of risk depending upon their risk aversion and time horizons. As with profits, there are some general principals that investors should know in order better manage their risks in investing.
1. Asset allocation can decrease risk. Diversification in stocks, bonds, commodities, currencies, etc., reduces risk to the investor's total investment portfolio because asset classes usually respond differently to external drivers in the market. However, lately there has been an increasing tendency for investment classes to move together, which adds a market-driven risk in addition to the fundamental risk inherent in the underlying security.
2. A longer time horizon can decrease an investor's risk. Markets go up and down and they can also melt up or crash. As long as an investor's time horizon is not tomorrow or even next year, the risk of investing is smoothed out over a longer time horizon. Historically the S&P has averaged an annual return of 8 percent. However, because of the recent burst of the housing bubble 12 years of S&P gains have been wiped out. The lesson learned is that asset bubbles create additional risk that investors have to be aware of.
3. Short term speculators create additional risk in the market. A sound piece of investment advice is to avoid the crowded trade being propelled by pure speculation. While playing a momentum trade can be very profitable, running with the short term speculator bulls is one of riskiest strategies.
4. Economic risks. There are a number of risks associated with investing that are not directly related to the underlying strength or weakness of the security or the dynamics within the marketplace. Economic conditions such as high cyclical unemployment and rising sovereign debt are playing an ever increasingly role in mounting new risks in investing.