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Your Wealth Journey Investment Insights – Managing the Market’s Risky Business

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Risk. It’s not just a board game in which you occupy strangely named provinces. Unless you’re a complete novice, and if you are --Welcome! --, you know that all investing carries risk. The trick is to avoid it the best you can. Diversification, as we’ve discussed in a previous post, is one tool in the fight against risk. Let’s dig a little deeper into why it works.

THE BASICS OF RISK

It’s important to know that there are two, broadly different kinds of risks: avoidable, concentrated risks and unavoidable market risks.

The risks of daily life are often readily visible and fairly uncomplicated. Don’t leave your shoelaces untied while running. Don’t leave spilled thumbtacks in the bathroom at night. It’s pretty simple.

Don’t be reckless, you’ll probably be fine.

But avoiding investment risk isn’t as straightforward as, “Don’t climb over the rail to take a 32nd floor selfie.” It’s important to know that there are two, broadly different kinds of risks: avoidable, concentrated risks and unavoidable market risks.

AVOIDABLE CONCENTRATED RISK

Concentrated risks are the ones that wreak targeted havoc on particular stocks, bonds or sectors. Even in a bull market, one company can experience an industrial accident, causing its stock to plummet. A municipality can default on a bond even when the wider economy is thriving. A natural disaster can strike an industry or region while the rest of the world thrives.

In the science of investing, concentrated risks are considered avoidable. You could still experience bad luck, but you can dramatically minimize its impact on your investments by diversifying your holdings widely and globally, as we noted in another article. When you’re well diversified, concentrated risk won’t throw you over the cliff because you are positioned to offset the damage done.

Your other, unaffected holdings can still carry water when if one sector leaks.

UNAVOIDABLE MARKET RISK

If concentrated risks are like bolts of lightning, market risks are encompassing downpours in which everyone gets wet. They are the persistent risks that apply to large swaths of the market.

At their highest level, market risks are those you face by investing in capital markets in any way, shape or form. Invest in the market and you’re exposed to market risk, no matter what.

RISKS AND EXPECTED REWARDS

In a previous article we explained that, through group intelligence, the market as a whole knows the differences between avoidable and unavoidable investment risks. Heeding this wisdom guides us in how to manage our own investing with a sensible, evidence-based approach.

MANAGING CONCENTRATED RISKS – If you try to beat the market by chasing particular stocks or sectors, you are exposing yourself to higher concentrated risks that could have been avoided with diversification.

This is your 32nd floor selfie. You could come out with with one epic photo, but you also might....not.

As such, you cannot expect to be consistently rewarded with premium returns for taking on concentrated risks.

MANAGING MARKET RISKS – Every investor faces market risks that cannot be “diversified away.” Those who stay invested when market risks are on the rise can expect to eventually be compensated for their steely resolve with higher returns.

However, those long-term investors also face higher odds that results may deviate from expectations, especially in the near-term. That’s why you want to take on as much, but no more market risk than is personally necessary.

Keeping your shoes tied might not look as cool, but you’re less likely to have road rash on your face in the end.

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Required Disclosure: "Diversification does not assure or guarantee better performance and cannot eliminate the risk of investment losses."