What is “risk” and why does the market go up and down so much?
“Risk” is not so much the possibility of losing an entire investment because
a company has gone bankrupt, “risk” instead refers to market volatility.
On a short term basis the market is irrational. The events of the day,
the emotions of the season move it up and down a lot. In an ordinary year
a stock can rise and fall 15% without any particularly dramatic cause.
That means that if you own a stock worth $100,000 at the beginning of the
year you can expect that at some time in the year it will be worth $115,000
and at some other time it will be $85,000. That is a huge swing and it
strains our emotional tolerance.
Risk is the emotional price we pay for the market’s superior returns.
Over roughly the last ninety years stocks have returned on average somewhere
close to 10%. That is far more than either bonds or a savings account,
which barely keep up with inflation.
A well diversified portfolio can offset market volatility. Different kinds
of stocks and bonds will move up and down at different times; while you
still get the benefit of the market’s better returns.