About 9 minutes
 
 
Investing helps us grow our wealth over time, which we covered in Investing Returns. But that’s only half the story, because we also have to talk about the risks of investing.
 

Here’s what we cover in this guide

Thinking about risk
Understanding market risk
Market risk extremes
Diversifying across asset classes
Understanding inflation risk
Balancing risks
 

Big picture – what is risk?

Well, this isn’t always an easy question to answer, because risk can mean different things in different situations. But when it comes to our finances, risk generally refers to the possibility of losing money, or more simply, not having enough money when you need it.
 
Unfortunately, most of us aren’t naturally great at understanding and managing risk. That’s because our emotional minds like to interfere. When things are going well (or when risk is hard to conceptualize), we have a tendency to underestimate the danger, which can cause us to let our guard down when we shouldn’t. Psychologists call this an optimism bias.
 
Alternatively, sometimes the opposite is true, like during a stock market crash when fear runs amok. This fear can cause us to overestimate the true risk at hand. And we might be tempted to sell our investments at exactly the worst time instead of waiting it out.
 
Long story short, our emotions can lead us to make some bad financial decisions, particularly when it comes to estimating risk. So it’s important to have a realistic understanding of what financial risks are out there and then to take concrete steps to manage them.
 
Some of these risks can be covered by an emergency fund, and others can be covered by insurance. But when it comes to our investments, there are two big risks we want to consider;
 
1) Market Risk
 
2) Inflation Risk
 
So let’s break them down, starting with market risk.
 

Understanding Market Risk

Anytime you invest your money in specific stocks or bonds, you’re putting it at risk of those particular investments falling in value.
 
We generally expect stocks to increase in value over time and bonds to pay interest and eventually pay back their principal amounts. But it just doesn’t always work out that way. Any given investment can run into trouble. And that means you’ll always be taking on some amount of risk when you invest. For example, let’s say you own the stock of a company that goes out of business, you could end up losing your entire investment.
 
But this risk of loss can be managed. As we mentioned in our guide on diversification, you can reduce this risk by diversifying, which means spreading your money across multiple investments. In fact you can do this fairly easily by investing in funds, either mutual funds or exchange traded funds (ETFs) – both of which we covered in our Intro to Investing.
 
But reducing risk is not the same as eliminating risk.
 
And even if you diversify, the entire stock market, or a significant portion of it, can still fall in value at any given time. And this is what we mean by market risk.
 
When you invest in stocks, bonds, and other financial assets, their prices will fluctuate. These fluctuations depend on how much buying and selling occurs in financial markets. So if you need to sell your investments, you’ll be at the mercy of the market’s prices at that moment.
 
And as it turns out, different investments tend to fluctuate more than others. These are said to be more volatile, or have higher volatility. For the most part, stocks tend to be more volatile than bonds, and real estate is usually somewhere in between.
 
But, with higher market risk comes higher potential reward. In fact, there’s a direct relationship between market risk and return. Investments that have higher market risk, meaning they fluctuate more in price, tend to earn higher returns over time.
 

Higher market risk (more volatility) = higher returns over time

Market Risk extremes

So how bad can things get investing in stocks?
 
Without a doubt, the worst period for stock investors in the last hundred years was the 1929 stock market crash, which was then followed by two years of continued declines and the Great Depression.
 
Leading up to the crash, the stock market generated large gains throughout the Roaring Twenties. This spurred unbridled investment confidence and instant riches for the daring. But all good things must come to an end, and end they did.
 
From its 1929 high to its 1932 low, the market lost roughly 90% of its value.
 
It’s hard to appreciate just how grim this was for investors. If you had invested $100,000 at the peak in 1929, your investment would have fallen to about $10,000. And, equally unnerving, the market didn’t return to its peak until the mid-1950s, more than twenty years later.
 

Less extreme extremes

Okay, admittedly the crash of 1929 was an extreme and rare occurrence. After all, we’re still talking about it all these years later. And while something like it could certainly happen again, trying to plan for an event like that will make it virtually impossible to take on any investment risk at all. And that’s not a realistic plan for most of us.
 
However, there have been other, less extreme, yet painful periods for investors.
 
In 1987, on what’s now know as Black Monday, the stock market lost over 20% of its value in a single day. It was a mind-numbing loss for those who experienced it. And during the crash of 2008, markets declined by roughly 50% over the course of several months, sometimes dropping by more than 5% in a day. The market recovered fairly quickly (within a few years) after both of these events, but there’s no guarantee that will always happen.
 
Starting in 2000, the bursting of the dot-com bubble caused the stock market to lose roughly half of its value over several years, with technology stocks faring significantly worse. The S&P 500 didn’t recover its peak value until 2007, which was shortly thereafter followed by the 2008 crash. Many technology stocks never recovered.
 
Additionally, smaller drops and crashes happen more regularly.
 
Bear markets (which are defined by a market decline of 20% or more) tend to occur every few years. Market corrections (a drop of 10% or more) occur about once a year on average. And daily declines of 1% or more are fairly common.
 
So given the possibility of large declines in stocks prices, what should you do, if anything?
 

Diversifying across asset classes

In the same way you can create a portfolio of multiple stocks, you can go one step further and create a portfolio of multiple asset classes (stocks, bonds, real estate, cash).
 
Why does this work? Well, sometimes stock prices will be falling while real estate prices or bond prices are rising, or vice versa.
 
Or, if they’re all falling at once, bond prices might not fall by as much as stock prices. Simply put, as long as their price movements aren’t moving in perfect lock-step with one another, you’ll reduce your market risk by diversifying.
 
In the next section, Investing Portfolios, we’ll share more ideas on how to determine the right mix of assets for your portfolio.
 

Understanding Inflation Risk

Okay, it sounds like stocks can get into some pretty rough patches at times. So why not just invest all of your money in safer assets like bonds?
 
For one, as we mentioned, stocks tend to offer higher returns. So if you’re going to be investing for a while (meaning years and decades), the higher returns can outweigh the added risk. The longer your invest time horizon, the greater the benefit.
 
Also, investments with higher market risk, like stocks, tend to do a better job of protecting you against inflation risk. Over time, inflation erodes the value of your money, even money you’ve invested. And over enough years, it can significantly reduce the value of your assets.
 
Market risk tends to get a lot more attention than inflation risk. And it’s understandable. When the stock market tanks, people take notice and the media gets to cover all the agonizing details.
 
But when inflation slowly erodes several percentage points off our wealth every year, it’s typically not a newsworthy event. Often it goes completely unnoticed. However, the consequences can be just as severe over time. So we all need to understand this risk and take steps to manage it.
 

Protecting against inflation risk

As we mentioned, certain assets tend to do a better job keeping up with inflation. It’s a good idea to make sure at least some of your money is invested in them.
 
Stocks and real estate, for example, represent ownership in physical, or real, entities (ownership of a business with stocks and ownership of property with real estate). These tend to rise in value as inflation rises. So their returns tend to do a better job keeping up with inflation over time.
 
Bonds and cash, on the other hand, represent paper contracts. A bond is an agreement to repay borrowed money – and the payments (principal and interest) are specified in advance. And cash represents a claim on a financial deposit at a bank. Since both are effectively just contracts to receive specified dollar amounts in the future, they’re at risk if dollars lose value over time (ie inflation). In other words, they tend to be less effective at protecting our money from inflation.
 

Side Note: There is a special kind of Treasury bond called TIPS (Treasury Inflation-Protected Security) that is intentionally designed to keep up with inflation by adjusting the principal amount over time based on inflation. You can learn more here. Additionally, I bonds are another type of inflation protection bond that adjusts its interest rate every six months based on inflation. We have a mini guide that explains them in more detail.

Inflation Risk vs Market Risk

Since stocks tend to earn a higher return over time AND tend to do a better job keeping up with inflation than bonds, it might be tempting to invest all of your money in stocks. But you don’t want to forget about market risk. As we discussed, stocks tend to fluctuate in price more. And this can be a problem if you need to access your money in the near future and prices have declined.
 
Which brings up an important trade-off between market risk and inflation risk:
 

Investments that tend to have less inflation risk, like stocks and real estate, tend to have more market risk.
 
Investments that tend to have less market risk, like bonds and cash, tend to have more inflation risk.

 
So as you create and manage your portfolio, you’ll want to think about your market risk tolerance and your investment time horizon. But you’ll also want to consider the balance between market risk and inflation risk. For most of us, this means having a mix of both kinds of investments.
 

Balancing long-term and short-term

Another way to frame this is to think of inflation risk as being a long-term risk and market risk as being a short-term risk.
 
From one year to the next, inflation is unlikely to have a huge impact on your investments (as long as inflation rates are relatively low). But, over the long run, inflation will have a big impact.
 
Market risk, on the other hand, can have a big impact on your portfolio in the short term (think stock market crash), but over longer periods, the short-term fluctuations won’t matter as much.
 
This is why it’s generally recommended to hold more stocks if you have a long investment horizon (meaning you are investing for a long time period) and to hold more bonds if you have a shorter investment horizon.
 
Which, as it just so happens, brings us to our next topic, Investing Portfolios.
 
 

Key Take-Aways

1) Risk is about uncertainty of future events, and financial risk is about the possibility of not having enough money when you need it.

2) While some financial risks can be handled with an emergency fund and insurance, your investments will have some amount of market risk and inflation risk that should be managed with your portfolio.

3) Investments that tend to have more market risk (fluctuate in price more), like stocks, also tend to offer higher returns over time. Investments that have less market risk, like bonds, tend to offer lower returns over time.

4) Stocks and real estate, which represent ownership in physical entities, tend to do a better job protecting against inflation risk than paper contracts, like bonds and cash.

5) You can think of market risk as a near-term risk and inflation risk as a long-term risk. If you’re investing for the long term, you can generally accept more market risk (can hold more stocks) and if you’re investing for the short term, you can generally accept more inflation risk (you can hold more bonds).