What is Market Risk?

Because investments can rise or fall unexpectedly, the primary risk associated with an investment (the market risk) is characterized by the variability of returns produced by that investment. For example, an investment with a low variability of return is a savings account with a bank (low market risk). The bank pays a highly predictable interest rate. That interest rate also happens to be quite low. An internet stock is an investment with a high variability of return; it might quintuple, and it might fall 50% (high market risk).
The standard way to calculate the market risk of investing in a particular security is to calculate the standard deviation of its past prices. [Top]

What is risk tolerance and why is it so important?

Risk tolerance basically is the amount of psychological pain you're willing to suffer from your investments. For example, if your risk tolerance is high, you might feel fairly comfortable investing in futures contracts or other types of securities that can go up and down like a roller-coaster. But if your tolerance for risk is low, you should stick to more conservative investments that aren't subject to wide swings in value. No investment is worth losing sleep over. [Top]

How can diversification reduce my risk?

Portfolio risk can be reduced by diversification. The components of total risk are company risk (also called unsystematic risk), which can be reduced through diversification, and market risk (also called systematic risk), which can't. To illustrate, say all of your money was wrapped up in the stock of XYZ Corp., the largest widget maker in the world. XYZ is a fine firm, but this is still a risky proposition. First, XYZ's stock could be adversely affected by weakness in the overall stock market. This is market risk. Second, the stock could suffer if the widget industry falls on hard times. This is industry risk (unique to the industry, not the market as a whole). And third, XYZ stock could tumble for reasons unique to the company -- an unexpected shutdown of its plants, the loss of a key customer, or even the death of one of its key executives. This is company risk. About 70% of the risk you face as an investor is company risk.

If you instead had a little of your money in XYZ Corp.'s stock, a little money in a diversified mutual fund that owns several stocks, a little money in bonds and a little in real estate, the chances of your portfolio plunging suddenly would be greatly reduced. [Top]

What types of investments tend to have the highest risks?

It's difficult to lump different types of investments into broad risk categories, in part because the way you invest in them could increase or decrease your risk. For example, buying futures contracts on commodities is generally considered one of the riskiest investments you can make. But that risk is greatly reduced if you instead purchase options on those futures or you use derivatives to completely hedge spot (cash) positions. Since risk is based on volatility and uncertainty, buying futures contracts themselves would certainly be included in anyone's definition of high-risk investing. Other investments that should be left generally to risk-oriented traders include financial derivatives, junk bonds, speculative stocks and the mutual funds that buy them. Precious metals have traditionally been considered high-risk investments, although the value of gold and silver has traded in a fairly narrow range over the past couple of years. [Top]

What are some very low-risk investments?

Virtually risk-free investments include U.S. Treasury bonds, bills and notes, which are backed by the full faith and credit of the U.S. government, and deposits at banks where accounts are insured for up to $100,000 by the Federal Deposit Insurance Corp. But these investments protect only against the risk you won't get your money back. There's also inflation risk to consider. For example, if you buy a five-year, 5% certificate of deposit covered by FDIC insurance, and inflation soars to 10% , your principal will be losing 5% of its purchasing power each year. Also, Treasury bonds are risk-free only from a default basis. Treasury bond prices still move inversely to changes in interest rates. So there's really no such thing as a risk-free investment. [Top]

What are the risks of a mutual fund?

There are several risks. The main one is that the companies in which the fund has invested will perform poorly, suffer mismanagement or otherwise meet with misfortune. Another big risk is that some economic, political or other development will cause the overall market to fall, dragging down with it the holdings of your particular fund. These are risks you would face investing in individual stocks as well; at least mutual funds can offer diversification. But some risks are unique to mutual funds. The fund management, for instance, may be doing things you don't know about or wouldn't like if you did. What you think is a plain vanilla domestic equity-income fund might, in order to boost returns, invest in derivatives, invest overseas, or invest in growth companies that pay little or no dividend. In a downturn, you could be in for an unpleasant surprise. There is also the risk that the fund will under perform a benchmark index, which means that management fees aren't buying any added value. [Top]