Market Risk – What it is and What You Can Do

Market risk is the risk that you will lose money the markets.  In most cases, people are referring to the stock markets, but it’s certainly possible to lose money in other markets as well.  Market risk is a reality anytime you’re dealing with a security that has a price that can move up or down (most importantly down).  Even with “safe” investments like government bonds, it’s possible to sell something for substantially less than you paid for it.

Market risk is probably the first risk that comes to mind when people think about investing.  It’s the one that’s easiest to notice – you can see that the value of your assets has decreased, and you immediately know what that means: if you cash out today, that’s what you’d be worth.  However, it’s not the only type of risk out there, and that’s why some people are willing to put their money into bumpy markets.

Why Take Market Risk?

Isn’t it crazy to put your money into something that can lose money?  It depends on what your goals are and what the alternatives are.  When thinking of market risk, it might be helpful to think of the tradeoff between risk and reward.  If you take very little risk, you might expect to get little in return.  However, if you take a bigger risk, it only makes sense that you should be entitled to a larger reward (but it doesn’t mean you can ignore the risk).

So, people accept market risk because of the potential for higher returns.  There’s no guarantee that you’ll get those returns, nor can you know when the markets will move up and down, but you can hope that you’ll be rewarded for taking risk in the markets.

Managing The Risk

Unfortunately, market risk is quite unpredictable.  And that’s the point: markets would not be able to offer the potential for higher returns if everybody knew when to get in and out.  However, there are a few ways to manage the risks ou take, and to improve your chances of success.

Time tends to smooth things out.  If you assume that the markets will, overall, go up over the long term, then you can manage market risk by investing over the long term. Looking at things day to day (or even year to year) may be troubling.  You will feel every bump in the road and notice every threat.  However, there have always been threats and nasty things out there, but the stock markets have generally risen over time.  Flip through the history book if you need a little encouragement: we are no strangers to inflation, war, depression, and uncertainty.  These things tend to cycle back around over and over, and every time feels like it’s going to be the last time (this is important: there’s nothing wrong with being concerned about these issues, but it is helpful to get some perspective on the fact that we’ve made it through them before).

Different markets move differently.  diversification is another way to manage market risk.  That is, if you have all of your eggs in one basket (one market, or one type of market) then you know what’s going to happen if that basket gets dropped.  Spreading your money around into lots of different types of investments can help.  Some of those investments might not go down as much as others, and some investments might even move in the opposite direction.  If you have a nice mix of investments, you should not be derailed by problems in a single market.

All that said, bear in mind that diversification is just a basic tool – it’s not a magical tool.  It is still very possible to lose money when you diversify.  It may happen that the losses in one portion of your portfolio are so great that they drag your account balance down to a level you’re uncomfortable with.  It could also be the case that different types of investments will move in the same direction at the same time (even if that’s what you were trying to avoid).  In 2008, for example, stocks weren’t the only thing to lose money.  People were surprised to see meaningful losses in investments that were considered “safe” or “alternatives”.

Avoid Market Risk?

Market risk is one of the more troublesome risks because you’ll hear about it when something bad happens.  When markets go down, news headlines will proclaim doom and gloom, and a general sense of anxiety settles over the land.  It’s really not fun.  Even when things are going well, commentators will say the market got too high for it’s own good. So, should you just skip it altogether?

Market risk is probably a necessary evil if you need growth that is faster than inflation (over the long term).  Historically, over long periods of time, riskier investments have tended to return more than safer investments.  Of course, there’s no guarantee that the future will look like the past, but you might use the past as one of several signposts to help you make decisions.  If you completely avoid market risk, it’s likely that you’re exposing yourself to the risks of inflation and, in the case of retirement planning, longevity risk.

One of the best things you can do is decide how much risk you’re willing and able to take.  You don’t have to be completely in the market or completely out.  If it makes sense to take some market risk, figure out how much is appropriate.

Finally, there are ways to reduce market risk while staying in the markets. That may sound confusing, because it is confusing. There are products out there, called annuities, that may offer certain guarantees against market risk. Before you get too excited, you need to know that those products cost more, they’re complex, and they’re difficult to get out of once you’re in. Nobody is going to protect your money without taking a cut of it. Nevertheless, in some cases it might make sense for some of your money.

Other strategies can also “buy insurance” on your investments. For example, options strategies and complex mutual funds can reduce losses that happen in the market. However, those investments are also complicated, and the expenses of using them might or might not be worth it.