What is risk?
Risk as defined in financial planning is simply the likelihood that something unexpected happens, which meaningfully impacts the price of a security. That unexpected event could be positive or negative. A company being heavily damaged by a freak storm is an unexpected negative event. A company winning a lawsuit they were expected to lose is an unexpected positive event. Risk can be further divided into systematic and unsystematic risk. Unsystematic risk is the risk associated with a single company or industry. This risk can be reduced with diversification. Systematic risk is the risk associated with the entire market. People usually don’t care if the stocks they own experience unusual positive events because who would complain about making more money, but negative risk is a crucial metric to consider in a portfolio.
In a portfolio, risk has to be carefully monitored because every person has a risk tolerance. That tolerance is based on both how much money they have (their physical ability to withstand risk) and their psychological ability to handle risk. Someone can be very rich and thus theoretically be able to handle a lot of risk but emotionally is not willing to. While the stock market in the long run will go up, it might decline dramatically in the short term and individual securities could permanently be depressed. That can be too mentally stressful for some people. Therefore, these people would be more invested in non-stock assets than people with higher risk tolerance. Similar to the ballast in a boat, non-stock assets decrease in amplitude the swings within a stock portfolio.
Another way of reducing risk is with diversification. As mentioned above, diversification reduces unsystematic risk. If you diversify, the impact of a single company on your wealth becomes very small. That lower impact can be both a good thing and a bad thing. Remember, risk can be both positive and negative. The impact of good company results and bad company results are both reduced. There have been many people who have made money from very concentrated portfolios and there have been many people who have lost money from very concentrated portfolios. /span>
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Daniel and Eli
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