In an earlier post I introduced a new series that will lay out some of the key risks that accompany investing in various types of securities. This first entry will address the general market risk faced by stock investors.
Market Risk for Stocks
Market risk is risk that is driven by the ups and downs of the broad stock market, which is often impacted by the perception of the general economic environment. This is also referred to as “systematic risk”, and it is a simple reality of investing in the stock market. To the extent that you wish to enjoy the returns that the stock market provides, you don’t have much of a choice other than to take on some market risk. In other words, this risk is largely unavoidable.
This type of risk is also unpredictable. We have a readily available example of the evils that can be exacted by the market in the case of late 2007 to early 2009. The overall market lost more than 50% (depending on the index) over that time period. While much of that could have been avoided through diversification, as we’ll see in subsequent posts, steering clear of the market altogether would have been the only way to dodge losses completely.
As a side note, the losses experienced during that time frame were not, for most, a permanent loss of capital, unless an investor bailed out of the market completely and “went to cash”. That was not at all uncommon, and it underscores a key point here. Expectations of future earnings are the theoretical basis for the value of a company. The stock market is an aggregation of many publicly-traded companies. Consequently, the collective value of the stock market is the combined value of the expected earnings of all of those companies.
Still with me? If not, it may not matter in the short-term. That is because, in the short-term, the market can be extremely unpredictable. While there is plenty of data to suggest that earnings really do drive market values over the long-term, we don’t have a crystal ball that tells us what market values will be six months from now. The best way to cope with market risk is to focus on the long-term when investing in the stock market.