We all want to get rich from our investments. As the past year has shown, however, those gains don't come for free. To reap the profits of investing, you have to get comfortable with risk.
But when the market seems to move hundreds of points up and down every day, how can you avoid feeling like you're in way over your head? History can teach us valuable lessons. But to come up with a personal solution to the risk question, you also have to look at your own investing personality.
The new paradigm of risk
This bear market has blown away many of our preconceived notions of stock market risk. Consider: It's been 75 years since the S&P 500 was down as much in a single year as it is so far this year. Even during historically bad periods -- the oil crisis of the 1970s, the 1987 market crash, and the tech bust earlier this decade -- the market's drops didn't come as quickly as they have in 2008.
As a result, many rules of thumb about risk have proved completely inadequate this year. In the past, if you'd said you were willing to see your portfolio lose a third of its value in a single year, some risk questionnaires would have told you to invest 100% of your money in stocks. Yet the year's losses so far -- 38% to date for the S&P, after a rally from levels that had the market down nearly 50% -- easily eclipse that tolerance for risk.
In other words, no matter what people thought, few were really prepared to see stocks fall as much as they have.
It's all up to you
But as important as history and statistics are, they don't really determine your own personal risk tolerance. For insight on that, you have to look at your own reactions to this bear market.
For instance, one person I talk with a lot on the Fool's discussion boards decided last week that she had reached her breaking point. She wasn't sleeping, and every new piece of bad news made her fear for her retirement savings. So she sold off a significant chunk of her stock portfolio. Even though she believed in the long-term prospects for many of the companies, it couldn't fix how scared she felt right now.
If that's the reaction you're having, then it doesn't matter what history says: You took on too much risk in your portfolio. And unfortunately, now isn't the best time to find out that you're uncomfortable with risk. But with the market up roughly 20% from November's lows, it's not the worst time, either.
Here are four tips to get your risk levels where you want them.
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Understand your stocks. Here at the Fool, we strongly believe that it's not enough to know what to invest in; you also need to know why. So for instance, if you don't understand the first thing about how biotech companies work, don't put your money into Genentech (NYSE:DNA) or Myriad Genetics (NASDAQ:MYGN) -- even if they're outperforming the rest of the market.
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Even "safe" stocks fall. One of the toughest things about 2008 is how even the mighty have fallen. Most investors would have put Boeing (NYSE:BA) and Bank of America (NYSE:BAC) among the most secure blue-chip names several years ago, yet each has lost 50% or more of its value in the past year. So don't assume that what you own is completely safe -- no matter how well known your stocks are.
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Diversify. We've learned this year that when everything's down, it's tough to avoid losing money. But holding a diversified portfolio of stocks is still less risky than going all-in on one particular sector. Sure, with perfect foresight, you could've picked companies such as Family Dollar (NYSE:FDO) and Dollar Tree (NASDAQ:DLTR), whose businesses benefited when customers became more bargain-conscious. Yet when the economy recovers, another group will probably take their place at the top. Being diversified increases the chances that you'll own some of the winners no matter who they are.
- Get paid. When you're not sure how a company will perform, demand some income -- in the form of dividends. When tough times hit the economy, a company like General Electric (NYSE:GE) will inevitably suffer -- but that company's commitment to paying dividends means that shareholders will at least get something back every quarter.
Don't expect to master risk -- it takes nerves of steel not to get scared in markets like this. But once you grasp your own portfolio's true risk, you'll be in a better position to control it -- and to avoid panicking at exactly the wrong time.
For more on investing in a tough market:
- Which stocks will do best in 2009?
- Priceless advice from Warren Buffett.
- When a stock is doomed, don't buy it even if it's cheap.
