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Thursday, August 26, 2010

Understanding Stock Market Risk

"Take a chance! All life is a chance. The man who goes the furthest is generally the one who is willing to do and dare. The 'sure thing' boat never gets far from shore." - Dale Carnegie (1888 - 1955)

In 1998 Economics Professor and Nobel Prize winner Paul Samuelson (1915 - 2009) noted that: "Many people now believe that if they simply hold stocks long enough they will not, lose money for statistics have shown that since 1926 the U.S. equity market has not suffered a loss in any given 15 year."

He called it a fallacy, and conceded that it is truly likely that if you hold stocks over long periods of time that they would tend to produce returns higher than other assets. But to believe that it is a God given statement, Is simply not correct.

Investing and stock market risks do not go to zero over long periods, but there are many articles that reflect how risk goes down the longer the time period. What is seldom introduced is the fact that if there is a significant onetime loss, it can be monumentally overwhelming.

In any case, Samuelson noted that: "The problem is that when stock prices do turn down (as inevitably happens even in the strongest of bull markets) your optimistic equity exposure can overwhelm your gut level risk tolerance, leading to poor short-term judgments and even outright panic"

Risk is a complex, multidimensional concept that manifests itself in various ways. Risk is omnipresent and includes stock market crashes, corporate bankruptcies, currency devaluations, changes in sentiment, in inflation and interest rates, and even major changes in the tax code.

Risk is generally defined as return volatility, or the degree of ups and downs of returns. But there's more to risk than volatility. Risk and long-term reward are generally related. Risk is the chance that your actual return will be less than you expected.

People sometimes think that a good return can be achieved with little or no risk. Unfortunately, that's impossible. To achieve your objectives, you need to assume certain risks and avoid others. Your ability to handle risk is related closely to your individual circumstances, including your age, time horizon, liquidity needs, portfolio size, income, investment knowledge, and attitude toward price fluctuations.

What's highly risky to one individual may be no problem to another. Short-term fluctuations are not that relevant for long-term investors who have the discipline, patience, and understanding to deal with them. Stock funds are actually less risky than money market funds for those with long time horizons.

Well-informed investors are far less likely to let risk get the best of them. Those who understand the various elements of risk are better equipped to enjoy a profitable long-term investment journey.