To be a winning investor, know the risks

Most people who want to “avoid risk” actually mean they want to “avoid loss.” Removing everything from the market and put it in their mattress, a piggy bank or a money-market fund — all providing roughly the same return these days — protects against market risk, the chance that a “double-dip,” “flash crash” or any other incident will drive down the market price of their holdings to where they have a loss.

But that strategy leads to purchasing-power risk, which is the opposite end of the risk spectrum, the chance that their money doesn’t grow fast enough to keep pace with inflation.

There’s also interest-rate risk, a key factor in the current rate environment. Investors face potential income declines when a bond or certificate of deposit matures and they need to reinvest the money. Juicing returns using higher-yielding, longer-term securities creates the potential to get stuck losing ground to inflation if the rate trend changes.

Another concern is “shortfall risk,” which has more to do with the individual investor than the markets. This is the possibility that someone won’t have enough money to reach their goals. Many investors take this risk when they are too conservative during troublesome market times or too aggressive when things are good. Investors who were whole-hog into tech stocks during the Internet bubble got hammered when it popped; today’s sideline sitter, conversely, might be missing out on low-priced stocks as they wait until they’re more comfortable.

Finally, there’s timing risk, which is not so much about when you are buying or selling as it is about your personal time horizon. To put it simply, the chance of stocks making money over the next 20 years is high; the prospects for the next 18 months are murky. If you need money at a certain time, this risk must be factored into your asset allocation.

If the studies show anything, it’s that investors definitely don’t understand opportunity risk. Consider this the greed factor, the chance of missing out. Opportunity risk runs against innate human psychology, as people perceive opportunities at just the wrong times. They’ll jump to buy when the market is at the end of a good run and hesitate when the market has fallen to lows that have put quality companies on sale.

Even after all of those risks, there’s currency risk, credit risk and more.

Each and every type of risk deserves some consideration in portfolio construction.

So if you are an investor , the question should not be whether you are avoiding risk given current market conditions, but whether you have accepted enough different forms of it.

http://www.marketwatch.com/story/to-be-a-winning-investor-know-the-risks-2010-10-06?siteid=nwhpf