Company-specific risks. Operating risk and price risk are two factors contributing to short-term volatility of individual stocks.
Operating risk is the risk to the company as a business; it includes anything that might adversely affect a company's. Price risk, meanwhile, has more to do with the company's stock than with its business fundamentals -- how expensive is the stock compared with the company's earnings, cash flow or sales?
To limit company-specific risk, own a collection of stocks rather than just a few.
Economic risk. Inflation. Interest rates. Economic growth. Changes in these economic factors can lead to short-term volatility.
To limit economic risk, buy securities that do well in different economic scenarios. Bonds and high-yielding securities (such as utilities stocks and real-estate investment trusts), for example, generally perform poorly when interest rates rise; balance those investments with low- or no-yielding choices.
Country risk. Whether you invest only in U.S. stocks or put some dollars to work outside the U.S. market, you're exposing your portfolio to the risks of investing in that country. There's political risk, or the risk that the current leadership will change for the worse. Then there's the risk that the currency will lose its strength versus other currencies.
To limit country risk, do one of two things. If you own both U.S. and foreign securities, invest in a variety of markets. If you invest strictly in U.S. securities, be sure your investments aren't overly reliant on just one part of the world for their success. For example, make sure some of your companies have expanded internationally. They'll be more resilient than less-diverse companies when the U.S. economy slows.
How much volatility can you take?
In the ideal world, your time horizon and your goal would determine how much volatility you'd tolerate.
You're not an emotionless robot that doesn't react to volatility, though. You're human. As such, consider how volatility may interfere with your prospects for meeting your goal. Then do whatever you can in your portfolio to thwart the factors that lead to volatility. In other words, limit your risk by diversifying across a variety of markets and companies.
Finally, answer these questions to develop your investment philosophy about volatility and risk:
- How much of a loss can you accept from your portfolio each year?
- How much of a loss can you accept over a five-year period?
- How much risk can you accept from your individual investments?
- How do you plan to diversify your various investment risks (market, company-specific, economic and country)?
- What risk-related test will an investment have to pass before making it into your portfolio?
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