We all know that investing is risky. Anytime you put a dollar in the market, there is a chance that it will lose value. And in the recent market downturn, we've seen people's portfolios go down. So what is risk? Is it a big, scary unknown thing that you just have to live with in your investing? Or, is there a way to understand it and actually reduce it?
It turns out that there are several types of risks that people track in the market and try to manage. The two most fundamental types of risks that every investor should know about are the systematic risk and the specific risk. Systematic risk also known as the market risk and it’s the risk that things will go wrong in the big picture overall. It’s the risk that there will be war, there will be a pandemic, there will be an economic downturn or a recession. There will be inflation. And regardless of how good of an investor you are and what type of companies you invest in, your investments are most likely to decline in value. The good and the bad thing about the systematic risk is you can't really do much about it anyway.
The only way you can avoid systematic risk is to stay out of the market. And that's probably not a good thing.
The other type of risk is what we call specific risk, or company risk. This risk is related to the specific company that you're investing in. We call this specific because our opinion of a company and how it does is very subjective. If the company is in the right or the wrong industry, if it has a good or bad management, if it has good products, good services, it gets its pricing right, it gets its marketing, right -- if it does everything right, it will probably rise. If it gets things wrong, the value and the price of its stock will drop.
With the specific risk, you have more control. One thing you can do is just not invest in a company that you think has a lot of specific risk, but that's not easy. The better way you can take away specific risk is through diversification. In this context, it means investing in more than one company. Research shows that by the time you invest in about 40 stocks, you minimize specific risk and you are much more exposed to systematic risk.
When you invest for the long-term in a good portfolio of securities, you're assuming that some of your investments will go up and some will go down if you don't make good choices about the specific companies that you invest in. You know that overall, your investments will do okay if the markets are good, if the economy is good, if there is low level of systematic risk or concern in the markets.
The best way to be a long-term investor is to have life goals as well as time, risk capacity, patience and wisdom to stay invested win over the long-term.
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