Human beings are funny about risk. Optimists ignore it, usually at their peril. Many others give more weight to potential losses than to gains. That's called loss aversion.
So we err on both sides -- but what is risk exactly? An outcome we didn't expect. In investing, it's ending up with less money than when we started.
The best way to minimize risk is to hedge your bets, by spreading them among many different investments. That's called risk diversification. Think of it as "buying the whole market," taking many small risks instead of a few big ones.
In investing, hedge funds and investment banks employ hundreds of thousands of people to accurately estimate the risk of an asset's decrease in value. The two main asset classes they look at are stocks and bonds.
The value of stocks varies with company performance, so to project risk is to predict future revenues and cash flows for the business. The risk of buying a share in the company is that it will not perform as you anticipate. The value of bonds depends on the creditworthiness of the borrower.
What's the risk that a government will default, or that a company will underperform? Those questions are so complex that even highly paid, full-time professionals usually get them wrong. Some 80 percent of all mutual fund managers, who are paid to beat the market, actually don't do as well as diversified index funds.
As individual investors, we also confront our own irrational biases toward optimism and fear.
Some people hold too much of their net worth in cash because they're afraid of losing it. In investing, that leads to paralysis. Because even cash has a risk, which is that inflation will increase, and each dollar will be worth much less.
No asset class will make you safe, but a method will
Diversification is a simple way to make decisions in a complex, uncertain world.
You can take it one step further with an automated investment manager that will spread your risks as widely as possible, so your financial outcomes are not linked to any one company, or to your emotions.
This is where FutureAdvisor comes in. Link your account to our evaluation engine, and we'll show you how to automatically balance your risks. You can get smart about risk now, if you don't let your emotions lead you astray.