Risk

Generically, risk is the chance that something bad will happen, and this is a perfectly apt definition in the world of investing as well. But because this leaves little room for measurement, risk in the context of investing simply refers to the variability of investment returns.

The great trade-off in investing, of course, is between risk and return. Risky investments usually must offer at least some hope of a higher return than extremely safe investments. To invest successfully, it's important to understand the nature of the risks you face as well as your attitude toward them.

Imagine you are a bond holder. The primary risks you face are credit risk (the chance that you won't get your money back); market risk (the chance that interest rates will soar, reducing the value of your dividends as well as of your bond); and inflation risk (the chance that rising price levels will erode the buying power of the dividends your receive). These same risks, in different forms, beset stockholders. They face company-specific risk (bad products, bad management, or bad luck, for instance); market risk (the stock market crashes and your otherwise excellent company is dragged down along with everything else); and inflation risk (which plays havoc with everything). That last one is particularly insidious. A classic mistake made by many investors is stashing all their money in safe, quiet certificates of deposit, only to discover 20 years later that their buying power has been halved.

Now, as to attitude, the question is, how much risk can you take? That depends on a variety of factors. How old are you? What is your earnings potential? What is your investment horizon? Do you prefer bungee jumping, downhill skiing, walking your dog or canasta? Remember, you can moderate risk through diversification and time.

Measuring the risk of anything is difficult, but as a first step, consider the return available on a risk-free investment, such as Treasury securities or a government insured certificate of deposit. Any return on an investment in excess of this is a reward for risk, or a risk premium. Standard measures of investment risk include alpha and beta.

 

 

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