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Invest better: what you need to know about risk

How “risky” is your portfolio? If you asked a group of retail investors what made a stock “risky”, you might get some commonsense answers about business risks such as exploring for gold and not finding any or an exposure to falling iron ore prices. Perhaps they might mention something about the running of the business such as a high level of debt or missed revenue targets. You might hear that the stock price is too high or that there isn’t any “margin of safety”. Clearly “risk” in these evaluations is the risk of losing money if you bought the stock.

Turn to theories of portfolio construction and risk is something quite different. Here “risk” is how much the stock price deviates over time — regardless as to whether it goes up or down. If you strip out all the technical sounding stuff, the basic theory assumes that stock prices are predictable with a measure of “risk” being a variance around this prediction.

Portfolio theory allows calculations as to the effect of adding assets to a portfolio depending on the risk and the correlation of price movements with existing assets. Theoretically you can reduce the level of portfolio risk by adding stocks to it until it gets to about 30 holdings, which, incidentally, is widely quoted as the magic number of stocks you should hold.

As Nils Bohr, Nobel Laureate in physics famously said, “Prediction is very difficult, especially if it’s about the future”. Models based solely on past share price movements might (just) have something to tell you about the immediate future, but if you are investing in real businesses for the long term, it is real business risks that you have to worry about. When Warren Buffett was asked about how academics regarded his approach to investments, he claimed they said, “Well, it might work in practice, but it will never work in theory”.

Foolish takeaway

Be careful if you hear or read people talking about “risk” in connection with investments. Real risk is the risk of losing money and, at the very least, you should try to understand why you are making any investment before you risk your money .

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Motley Fool contributor Tony Reardon does not own any of the shares mentioned in this article. The Motley Fool’s purpose is to help the world invest, better. Take Stock is The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it’s still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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