Stock Selection risk can be defined as the probability that the return of a portfolio composed of individual stocks will be worse from an expected benchmark. Historically, this type of risk has been the one most commonly considered by investors. Modern investment tools, such as ETFs that follow the benchmark index, can now neuter this risk and let the investor concentrate on sector and market risks only (discussed in previous articles in this series).
Sector allocation as a risk is often ignored by the novice investor. The lack of adequate tools in the past has caused many investors to look at the market as a whole or to pick and choose individual stocks. What was often neglected is the tendency of stocks within the same sector to move in unison. Overweighting a declining sector or underweighting the one on the rise (done implicitly by choosing specific stocks) can adversely affect the portfolio. The alternative of using sector funds carries the risk of owning the wrong fund at the wrong time, adds trading and tax costs and may hinder the performance as well.
Market risk is undoubtedly the most significant risk component for the equity investor. When the market falls, almost everything dives with it. When it rises, it pulls up some bad apples as well. The savvy investor should recognize this reality and act according to the famous quote by Warren Buffett: “look at market fluctuations as your friend rather than your enemy”. Naturally, this is easier said than done, but with recently introduced data driven tools, this daunting task can become more manageable and disciplined.
Risk is an inherent part of our life. In the immortal words of President Theodore Roosevelt: “Risk is like fire: if controlled it will help you; if uncontrolled it will rise up and destroy you.” In the world of investments, taking risks is a prerequisite for achieving returns, and controlling the risk is the key for a successful investment.