Investing is all about putting your money at risk to allow you to make money. Because you’re putting your money at risk, you can require that others pay you for taking the risk. And that’s the real secret: You need to be paid enough for taking the risk that you end up making more when you win then you lose when you fail. If you then make several different investments, such that you have wins and losses, the money you make on your wins will be more than the money you lose on your failures and you’ll make money overall.

Today we’ll talk about the different types of risks investors face and how to manage them.

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Single Asset Risk

Single asset risk is the risk that a stock, rental home, or other asset will have something happen to it. For example, a company could fail to change with the markets and see revenues collapse. There could be a flood in a rental that makes it unrentable for several months while you clean up the mold that results.

The way to guard against single asset risk is though diversification. Assuming random selection, there is probably between a 1% and 5% chance that any stock you pick will fall down and never recover back to where it was. If you buy 100 stocks, you are then likely to only lose between 1 and 5% of your portfolio value when this happens. Because other stocks in that portfolio will perform well, the losses you see from the few failures will be covered by the stocks that do well and you’ll end up making money. Because the amount you make on the stocks that do well on average is more than you lose on the stocks that fail, you’ll see positive returns on a set of stocks over time. Long-term returns of around 10% have been seen in the past for large US companies, for example.

Mutual funds, which include index funds and ETFs, buy a set of stocks. When you buy into them, you are automatically invested into many different stocks. This is an easy way to get diversification and avoid single asset risk. REITs are a way to do this with real estate.

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Sector Risk

Let’s say that you buy a US large company ETF like an S&P500 fund or the NASDAQ Q’s and then the US goes through a recession. In this case, your ETF will decline in value because everything will go down, good and bad, within the US markets. This drops won’t last forever, but you can easily see a drop of 10%, 20%, or even more in your ETF. The whole sector, Large US stocks, is going through a recession and people are selling all of them. This is called sector risk.

The way you combat sector risk is by buying into many different sectors. Instead of just buying a large company US stock fund, buy a small US stock fund, a non-US large stock fund, and an emerging markets fund. Maybe also buy into a bond fund and an REIT fund. By adding different types of assets, you’ll be avoiding the risk that one type of asset will go through a bear market and drag down your portfolio as well.

When one sector is down, others may be up. This also means that you’ll always be in whatever sector is doing best at the time. (It also means that you’ll never have everything in whatever is doing the best at any given time, but the best sector will rotate among your holdings and everything will be your star performer in its time.)

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Investing to Win

Timing Risk

Even if you buy every stock in the market, there will be times when business contracts and the whole market will decline. Because world markets are connected, there will be times when even owning stocks all over the world will not help you. This is timing risk, where you buy in right before the markets all decide to fall.

The way to combat timing risk is to buy for long periods of time. Bear markets (when assets decline) generally last for a few months to a year or two. If you hold on through these periods, the markets have always recovered and gone on to gains that more than make up for the losses. If you’re buying a given type of assets, you need to be able to hold on long enough to nearly ensure a positive gain that is somewhat predictable based on history. For stocks this is about 10 years. Other assets require different holding periods. (Yes, things can change, but as long as the economy continues to be about the same, we should see about the same gains.)

Some people think that they can see when declines are about to occur and sell. They also think they can buy right before stocks go way up. Most of the big gains in the markets, however, occur over very short periods of time. If you are not invested during that week or two when stocks skyrocket, instead of a 10% return, you may only have a 1% return. Attempts to time the markets generally fail. It is better to just buy in and hold on.

If you need the money relatively soon, it is best to go ahead and sell and go into cash. If you have some flexibility where you could wait a year or two if the markets go sideways, you can still invest in assets like stocks even though you could see a big decline. If you absolutely must have the cash within a certain time period, you should not have the money invested.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.