When you invest you take on several different kinds of risk, including:

Purchasing power risk. When money is in your mattress, you’ll earn no return on those funds. And when you later use that money to purchase something, you’ll find that your dollar can buy less than it might have when you first stashed it away. This is a result of inflation—the items we need are likely to be more expensive in the future than they are now. This is the most basic investment risk you can accept: that your returns won’t keep up with the inflation rate over the life of the investment.

Credit risk. When you invest in fixed income securities, you accept the risk that the interest payer will become unable to make the payments. If a company is not able to make an interest payment, or return the principal at maturity, the bonds are said to be in default.

Principal risk. Bond investors are also subject to fluctuating market value on the principal of their investment. This is because bonds generally trade in the open market at a current price that will produce a current yield to new buyers in accord with prevailing interest rates. This means that after a bond is initially issued, rising interest rates will force the current market value of a bond down. This risk only matters if a bondholder seeks to liquidate an investment prior to maturity. If the bond is held to maturity, the investor will receive a return of the original investment.

Market risk. Stock investors own shares of a company with management, products, and financial results. Even when a particular business successful, if the market as a whole goes into a decline, it often takes most stocks with it. This is market risk.

Company risk. On the other hand, even in a risking stock market, if a company loses ground to competitors, or sees their product line become obsolete, or mismanages their finances, the stock in the company may decline regardless of overall market health.

To address these risks, it’s important to 1) diversify, and 2) have a strategy.

1. Diversification: A basic way to manage investment risk is to diversify your investment holdings. For example, holding several stocks instead of one means that you’ll likely reduce the volatility of the holdings as a group, because you’ll reduce the impact that one company’s bad news can have on your portfolio. If the group of stocks you hold are in different sectors or industries, you reduce your risk still further.

Taken to another level, beyond simply the particular stocks you hold, if you diversify your investments across different asset classes—holding some stock, some bonds, and some cash—you reduce risk even more. True diversification means not only holding some percentage of a portfolio in low-risk instruments like cash, some portion in fixed income, and some in equities. It also means diversifying each of these asset classes across economic sectors, geography, and company size and style.

2. Risk management strategies: Traders need to understand their risk. Successful traders accept risk and take steps to manage it. At the foundation of managing trading risk is having a sell discipline, and that starts with defining exit points when a position is initiated. When successful traders buy a stock, they have a target price in mind, and when that target is reached they start to exit the position. At the same time, they decide how much loss they’re willing to accept, usually limiting their acceptable loss to a set dollar or percentage amount. So:

- Determine a target price.
- Know your profit target.
- Know your loss limit.
- Use alerts to know when important price points are reached.
- Use stops, either “mental” (know and stick to your exit point) or actual stop orders.
- Don’t think of your exists as “good-til-close”!

In short: Before you enter a trade, have a clear idea of the amount you expect to make if it goes your way, and at what level you will exit quickly if it does not. Have rules, and always adhere to them. To read more about creating a trading strategy, see the section Make a Move: Selecting a Stock > Start with a Strategy.

Read more:

The Importance Of Diversification
Without this risk-reduction technique, your chance of loss will be unnecessarily high.

Do You Understand Investment Risk?
Many investors overestimate their level of financial knowledge.

Protect Yourself from Market Loss
There are several simple strategies you can use to protect yourself from downside risk.

Limiting Losses
It is impossible to avoid them completely, but there is a systematic method you can use to control them.