Keeping your investments low risk is crucial to becoming a successful self directed investor.

(We apologize for the length of this article but knowing about risk is very important!)

Investment risks, like beauty, are often in the eyes of the beholder.  Nearly every blog, web site, and even academic publication has different names and notions of investment risk.  Inherently we all think we know what investment risk is but we encourage you to pause and rethink risk.

Here is a list of investment risks from Enough Wealth (no endorsement implied).

• Inflation - the chance the money you have invested will decline in real value due to inflation.
• Principal - the chance that your original investment will decline in value or be lost entirely.
• Credit - the chance a borrower will default on an obligation.
• Market - the likelihood that a broad investment market, such as the bond or stock market, will decline in value.
• Liquidity - the possibility you won't be able to sell or convert a security into cash when you need the money.
• Interest Rate - the variability in a security's return resulting from changes in the level of interest rates
• Regulation - The risk of a regulatory change that could adversely affect the stature of an investment (eg. changes to the tax law)
• Business - the risk of doing business in a particular industry or environment is called business risk
• Reinvestment - the risk that dividends/coupons will not be reinvested, or cannot be reinvested at the same rate, so that yield to maturity (YTM) isn't attained.
• Exchange Rate - the variability in returns on securities caused by currency fluctuations (aka "currency risk")
• Country - the chance of loss due to stability and viability of a country's economy (aka "political risk")
• Valuation - the chance that an investment is overvalued (eg. bubbles)
• Timing - the chance that other factors cause you to buy or sell an investment at an inappropriate time
• Forced Sale - the chance that an investment is liquidated involuntarily eg. takeover, fund closure

The problem with financial risk is that you can minimize it but you can't eliminate it.  If you take one extreme and simply hide your money in a mattress then Inflation Risk will get it.  If you take the opposite extreme and invest too aggressively then any of several other risks can eliminate you money in a heartbeat.   The typical way we manage risk is with diversification and asset allocation .  Each asset class has a different risk:return ratio so by balancing different asset classes in a portfolio you can achieve your investment risk comfort level.  In this graph by Campbell Harvey of Duke University you can see the historical growth of five common asset classes. (See our next article for more information on asset allocation.)

First, look at the brown "Inflation" line.  Notice that all five asset classes track or exceed the inflation rate line.  Also notice that there is a HUGE difference between US 30 Day T-bill which mostly tracks inflation and the US Small Cap Stock that returned a LOT more.  How much more?  If you invested $1000 in T-bills in 1925 it would have been worth $12,500 in 1995 but if you had invested the same $1000 in Small Cap Stocks it would have grown to $3.5 million!

In simple terms an investor mitigates the overall risk of the portfolio by investing in different proportions of each asset class using index based investment vehicles.  Here's how you do it.

• Mitigate the risk of Inflation by simply making the decision to invest.  As shown above only if you do NOTHING do you lose money to inflation.
• Be aware but don't worry about the ones you can't easily control.
  
  • Regulation - The risk of a regulatory change that could adversely affect the stature of an investment (eg. changes to the tax law)
  • Exchange Rate - the variability in returns on securities caused by currency fluctuations (aka "currency risk")
  • Forced Sale - the chance that an investment is liquidated involuntarily eg. takeover, fund closure
  • Timing - the chance that other factors cause you to buy or sell an investment at an inappropriate time
• Reduce the ones you can by selecting the most appropriate investment vehicle.  It is no secret that we suggest Exchange Traded Funds traded on US exchanges.  Selecting solid Index ETFs will mitigate these risks mostly through diversification.
  • Credit - the chance a borrower will default on an obligation.
  • Liquidity - the possibility you won't be able to sell or convert a security into cash when you need the money.
  • Interest Rate - the variability in a security's return resulting from changes in the level of interest rates
  • Business - the risk of doing business in a particular industry or environment is called business risk
  • Reinvestment - the risk that dividends/coupons will not be reinvested, or cannot be reinvested at the same rate, so that yield to maturity (YTM) isn't attained.
  • Country - the chance of loss due to stability and viability of a country's economy (aka "political risk")
  • Valuation - the chance that a an investment is overvalued (eg. bubbles)
• That leaves these investment risks:
  • Principal - the chance that your original investment will decline in value or be lost entirely.
  • Market - the likelihood that a broad investment market, such as the bond or stock market, will decline in value.

These two are the focus of our strategies at TimingTruth.  Here is how we mitigate these two.

• Principal risk - If you invest in individual stocks this risk is significant but if you invest in 500 different companies then the relative decline (or even failure) of a few will not significantly impact the overall investment.  This is diversification at work.  This is exactly why we use Index ETFs as our primary investment instruments.  If you buy "sectored" funds you lose much of the diversification a fund approach gives you and increase your risks.  We have not seen that the returns outweigh the risks so we stick with Index funds and leave the others to the market speculators.
• Market risk - It is true that broad markets will go through economic cycles.  If you adopt a BUY&HOLD investment strategy this is a significant risk for you.  As many experienced during 2008-9 that many years of growth can be wiped out in a few months of a bad market cycle.  Our major focus at TimingTruth is to carefully analyze these broad markets and determine where they are in an economic cycle.  No one can determine the absolute tops or bottoms of these cycles but many do identify them close enough to avoid the huge losses we've just experienced.  (Note: We compare our strategies to a Buy & Hold strategy in all our graphs to make it easy for you to see the difference.)