Investing Classroom: How much risk can you take?

Husbands endure Saturday-evening dinners with their in-laws in exchange for a Sunday of uninterrupted football. Kids pass up watching television to hoover and wash dishes because they want spending money. And parents extend Friday night curfews as a reward for good behaviour during the week.

Life is about trade-offs. So is investing.

The investment trade-off is between risk and return. Getting a return on your investment means accepting risk, at least to some extent. But what, exactly, is risk? And how much of it can you tolerate?

This course will review the types of risk involved in investing, and show you how to develop your philosophy about investment risk.

Two general risks
Investors face two general types of risk.

First, there's the risk of losing money over the short term. Whilst the stock market generally increases its value as the years progress, odd years will inevitably display market downturns, as we have seen only too clearly in 2008-09.

And over shorter time periods--a few weeks or months--investments can be even more volatile.

Investors focus almost exclusively on this type of risk. It's easy to do. Every day you hear about how the market is doing on the radio and television. And if that's not enough, you can check your stock prices throughout the day.

Don't let volatility get the better of you, though. If you do, you'll virtually ignore the second and perhaps even greater risk that comes with investing: the risk that you won't meet your goals.

How can obsessing about volatility get in the way of your goals? It may cause you to invest too conservatively. Volatility also may lead you to buy or sell an investment based on short-term performance rather than on how this purchase or sale will help you reach your goal. In short, volatility can prevent you from seeing the forest for the trees.

Weigh how important reaching your goal is against how much short-term volatility you're willing to accept.

Contributors to volatility
When thinking about short-term volatility and your acceptance of it, consider some of the specific risks associated with investing. Think of volatility as the byproduct of risk: When a hidden risk manifests itself, volatility ensues. But by diversifying your portfolio, you can reduce the impact of any one of these risk factors, and therefore limit your short-term volatility.

Market risk: Market risk comes with exposure to a particular asset class or sector, such as equities or technology stocks. It's the threat of the entire market losing money. That can happen if investors think that the stock market is selling well above its prospects, for example, or that technology stocks as a group are going to face slower growth.

To limit market risk, diversify into various markets and sectors. By doing so, you're reducing your portfolio's dependence on a single market.

Company-specific risks: Operating risk and price risk are two factors contributing to short-term volatility of individual stocks.

Operating risk is the risk to the company as a business and includes anything that might adversely affect the firm's profitability. Price risk, meanwhile, has more to do with the company's stock than with its business: How expensive is the stock compared with the company's earnings, cash flow, or sales?

To limit company-specific risk, own a collection of stocks rather than just a few.

Economic risk: Inflation. Interest rates. Economic growth. Changes in these economic factors--or even rumours of changes in these economic factors--can lead to short-term volatility.

To limit economic risk, buy securities that do well in different economic scenarios. Bonds and high-yielding securities (such as utilities stocks and real-estate investment trusts), for example, generally perform poorly when interest rates rise; balance those investments with low- or no-yielding choices.

Country risk: Whether you invest only in UK stocks or put money outside the UK market, you're exposing your portfolio to the risks of investing in that country. There's political risk, or the risk that the current leadership will change for the worse. Then there's the risk that the currency will lose its strength versus other currencies.

To limit country risk, do one of two things. If you own both UK and foreign securities, invest in a variety of markets, not just a few. If you invest strictly in UK securities, be sure your investments aren't overly reliant on just one part of the world for their success. For example, make sure some of your companies have expanded internationally. They'll probably be more resilient than less-diverse companies when the UK economy slows.

How much volatility can you take?
In the ideal world, your time horizon and your goal would determine how much volatility you'd tolerate.

You're not an emotionless robot that doesn't react to volatility, though. You're human. As such, consider how volatility may interfere with you meeting your goal. Then do whatever you can in your portfolio to thwart the factors that lead to volatility. In other words, limit your risk by diversifying across a variety of markets and companies.

Finally, answer these questions to develop your investment philosophy about volatility and risk.

1. How much of a loss can you accept from your portfolio each year?

2. How much of a loss can you accept over a five-year period?

3. How much risk can you accept from your individual investments?

4. How do you plan to diversify your various investment risks (market, company-specific, economic, and country)?

5. What risk-related test will an investment have to pass before making it into your portfolio?