last updated February 22, 2015

Not all investments are the same. A thousand dollars invested by one person may grow ten or twenty times, whereas the same thousand dollars invested by another may in fact lose money. Stocks, bonds, funds, and other places to put your money are all different; they have different levels of investment safety .

Even though an investment can seem safe on the surface (in that it offers a good return after taxes and inflation), it can be risky due to factors inherent in the investment itself. If you want to build real wealth in the stock market, you need to understand where intrinsic risk comes from and how to manage it.

What Makes an Investment Risky?

Apart from more exotic investments such as options and futures, the intrinsic risk of any stock is that the company will go out of business and you’ll lose all the money you spent buying the stock. (What about dividends you’ve received? You get to keep those, though a company in financial trouble probably won’t pay dividends .)

This risk is present in any stockeven Coca-Cola could go bankruptbut it’s less likely for good stocks. What keeps a good stock likely to stay good is the strength of the company in several aspects, including but not limited to:

• The quality of upper management
• The presence of a durable competitive advantage (a moat)
• The reliability of earnings
• The periodicity of the business
• The debt structure and return on invested capital of the business
• The sector and industry of the business
• The size of the business

These aren’t the only factors, but if you know enough about the business to assess these factors, you can get a good idea of the underlying risk. Keep in mind, though, that the risk of losing all of your money is serious, but so is the risk of making less return than if you invested in a better company.

Why Do Some Investors Pursue Risk?

Have you ever bought a lottery ticket? You pay your $2 for the chance to win millions of dollars. The odds of winning that money are terrible, but millions of people buy tickets anyway. The expected payoff is high and the penalty (losing $2 and having nothing to show for it but the entertainment of dreaming What if I won?) is small.

Investing $10,000 in a new, high-tech startup with no earnings and only the possibility that one day it’ll be the next Amazon or Facebook is a similar principle. In the absence of strict metrics to run past the risk criteria described earlier, you have to tell a story about your hope that this little company will outperform the market and find a profitable niche from which to grow quickly (lest it suffer the fate of the other 99.9% of high tech startups).

Unless there are other no risk, no reward investors lining up to throw money at this company, you can probably buy shares of its stock cheaply. The market tends toward efficient pricing (no revenue? what’s it worth liquidated?) which you can measure via methods such as intrinsic value and discounted cash flow. This is one reason penny stocks are so cheap. Their businesses are worthless and probably won’t ever turn around.

Yet there’s always a chance. and you can decide what that chance is worth. (Generally, nothing, but if you have money to burn. )

How Can You Avoid Risk in Your Investments?

You can’t avoid all risk in investing. There are too many factors to predict, from the interconnections of the global economy to human error and malfeasance to the impossibly complex web of human desire, fear, and behavior which governs how all of the shareholders of a stock trade over time.

You can stick with good stocks. Pick companies with known histories. Pick companies which have trends of making money. Pick businesses which have demonstrated that they know how to navigate the competitive landscape of modern business and generate real revenue for their shareholders.

Can Diversification Reduce Risk?

Some advisors suggest that diversifying your investments across sectors and industries helps you avoid risk. That’s not necessarily true. Obviously, if you’ve done your homework and chosen five really great companies and bought them at good prices, the risk of you losing your money from all five companies going out of business is less than the risk of losing your money if you invested in only one doomed company.

That kind of diversificationinvesting in several good companiesis good. It’s done with research and thought. One of the drawbacks of diversity for its own sake (buying shares of every company in a sector or one company in every industry) is when you have an equal chance of buying shares of a good company as shares of a bad company.

Does the S&P 500 index apply? Certainly some companies underperform every year and get removed from the index and other companies outperform and never make it to the index, but the fact that you have the 500 largest companies in American business coupled with the fact that very few professionally managed funds match the performance of the index on a regular basis, especially when accounting for risk and broker fees means that this is one case where broad diversification is worthwhile. (This is especially true, considering how boringly good this index fund is.)

In short, diversification is good when you spread the risk around good companies. It’s useless (perhaps even harmful) otherwise.

Do Risky Stocks Guarantee Bigger Rewards?

Why do people buy risky stocks, if they understand the risks? In rational terms, it makes sense to do so only when the present value of the expected payout is worth the risk of losing everything. Dropping $2 on a lottery ticket every now and then won’t break the bank (though you’re likely to get a better result saving that money and investing it over a period of decades). Dropping your entire $20,000 budget into a single penny stock will end in tears.

The mathematics of a stock going from $0.10 per share to $10.00 per share look impressive, but the likelihood of a company going from just about worthless to worthwhile in the time it would take to get your money back is low. That’s the risk. There are safer investments which probably will never have the possibility of earning you 100x what you’ve invested, but which will produce a boring, safe return of 15% a yearand you won’t have to be glued to stock pages, worrying that you’ll miss that split-second window in which you can buy and sell.

After allyou have to pay for the risk by convincing yourself there’s a bigger reward and by suffering through the psychological strain of continually worrying that you’re going to lose everything.

Stick with $2 on a lottery ticket every now and then, if you feel the need to dream big and invest a little bit of money on a losing proposition.

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