One of Peter Lynch’s most famed principles of investing is “Invest in what you know.”

I humbly disagree.

You Don’t Actually Know

The only problem with that bit of advice is that, as human beings, we tend to have too high an opinion of our own intelligence and abilities. In other words, you think you “know” but you probably don’t actually know as much as you think you do, or as well as you think you do.

I was studying computer science at Carnegie Mellon University during the tech boom of the late nineties and (very) early 2000s. I saw all these technology companies offering great services and saw that there was a very bright future in technology. I saw that the future of commerce was online so I believed that companies like Amazon.com and Buy.com and Overstock.com would be the future powerhouses (none have reached they tech bubble peaks, but all are doing relatively well… though Overstock’s CEO keeps complaining about the shorts). The only problem is that while I knew basic computer science theories, I didn’t actually know much about technology companies and the business world. I thought I knew, but I didn’t.

Too Many Eggs In One Basket

Another reason this bit of advice is dangerous is because it depends localized knowledge and, more specifically, often knowledge of an industry you’re working in. That’s dangerous for the very same reasons why people often recommend that you don’t invest your 401(k) money in company stock. When you invest your 401(k) in your own company, you run the risk of being hit with a double whammy if a market downturn affects your company. You don’t want your long term retirement assets pegged to your job, right? While the reverse may still hold true, if things go well then they go doubly well for you, it’s a risk that simply isn’t worth it in the opinion of most financial advisers.

Diversify Everywhere

Let’s say that you really do know an industry inside and out, that’s still only one industry. While Lynch’s advice wasn’t that you should put 100% of your investments into any one thing, it could be misunderstood. If you’re supposed to invest in what you know, shouldn’t you invest it all in at least that industry? Or that one country? I live in the United States, I “know” the United States, does that mean I should invest in domestic markets only? Probably not.

Even Those Who Know, Don’t

In reading Full of Bull, I saw how weak industry analysts were at predicting the trends in the industries they were covering. They spend their entire days analyzing industries, far more than what you would do if you worked in that industry, yet they were unable to pick the winners from the losers with any consistency. While part of the reason was because they had to play the marketing game, the reality is that the market is more of a random walk than an orderly march. Even those who devote their entire careers to tracking specific industries aren’t good at picking the winners.

I know I took a good statement and twisted every which way but I think it’s valid. Don’t invest with what you know, invest in fund who are led by people who know a lot and who invest in a lot of things. Or buy an index fund.

One of the best things I ever did was read Wall Street: A History: From Its Beginnings to the Fall of Enron by Charles R. Geisst. In it, I learned about the famous tulip bulb craze in 1630s. During that craze, people were buying exotic colored tulips like they were going out of style (which they soon would) and many folks ended up with little more than a couple pretty flowers (check Wikipedia for the full scoop).

Let’s compare that with the dot com bubble and the housing craze and see if there are any similarities. In the dot com boom, investors were putting money into companies that were little more than an idea and a URL. In the tulip bulb boom, someone was able to sell shares in a company that claimed to one day be involved in the trading of tulip bulbs (this is based on my memory of what was included in Geisst’s book, there’s no mention of this on the Wikipedia page), only to run off with the money. In the housing craze, people were given 100% LTV loans based on the magic lenders were able to make in the books and not based on the borrower’s actual ability to pay (in this case, the lender was the investor). So in all three cases, the bubbles formed because people were so greedy that they invested in the “symbol” and not the fundamentals.

The lesson here is that you shouldn’t let greed cloud your judgments. Remember that Rule #1 is “don’t lose money.” Warren Buffett is plenty rich and he basically skipped the dot com boom. Some had written him off because he missed it but he said that he was just fine. Buffett only invests in things he can understand. He couldn’t understand why people were paying these ridiculous valuations for companies that had zero earnings.

So, the next time you see people acting all crazy (how many people told you to invest in a hot stock or to buy a house because it can’t do anything but go up?), don’t jump in. Watch from the sidelines and you’ll save yourself a lot of money.

(Photo: powi)

The key to a successful investment plan is to pick one that fits your personal style. If you’re always busy and simply can’t find the time to pay attention to your investments, you need to pick a style that matches your life. There’s no sense adjusting your life to your investments, it should be the other way around. It’s difficult to pigeonhole anyone into one particular bucket but find the various suggestions in each grouping to see how best to use them to match your life.

The Novice

Everyone starts as a novice, there’s absolutely no shame in being a beginner when it comes to the stock market. In fact, it’s probably better that you’re a beginner. It was the experts that got us into the whole sub-prime mortgage mess. Until they closed their doors, the halls of Bear Stearns was full of experts. That being said, if you’re a novice when it comes to the stock market, put your money into a high yield savings account and start playing with a “play portfolio” at one of the finance sites. While you’re learning, your savings will still earn a nice interest rate.

When I was learning, I used Yahoo! Finance and a tool over at The Motley Fool (if you’re a novice, The Motley Fool is a great place to learn more about the markets). You can use one of any number of play portfolios to hone your skills and get used to the stock market (without the pesky “losing money” part).

The Regular Joe (or Jane)

The Regular Joe is someone who likes to check up on stocks every once in a while (whether that’s once a day, once a week, or once a year) and keep up to date on the financial news. He or she has the time and inclination to read the news but simply isn’t terribly interested in everything that’s going on in the financial word. The solution? Try a “Lazy Portfolio.”

A lazy portfolios are buy-and-hold portfolios that consist of low-cost & no-load index funds. They are the bane of Wall Street and brokers hate them. They are created by financial experts and they perform quite well. Here are a few of the cooler sounding ones:

• Couch Potato: 50% Vanguard 500 Index & 50% Vanguard Total Bond Fund Index
• Sophisticated Couch Potato: 75% Vanguard 500 Index & 25% Vanguard Total Bond Fund Index
• Margarita: “One part total stock index, one part international stock index and one part inflation-protected Treasury securities.” (if you went Vanguard, that’d be 33% Total Stock Market Index fund, 33% Total International Stock Index fund, and 33% Inflation-Protected Securities Fund)
• Coffeehouse: 40% Intermediate Bond Index, 10% in each of Total Bond Index, S&P 500 Index Fund, Large-Cap Value Fund, Small-Cap Fund, Small-Cap Value Fund, International Fund, and a REIT index fund.
• No-Brainer: 25% in an S&P 500 Index Fund, Small-Cap Fund, European Stock Fund and a Total Bond Market Fund.

There are plenty of other options out there, and you don’t have to go with Vanguard, but those should get you started.

The Gambler

Everyone has a bit of gamble in them, some have more than others. I used to play quite a bit of online poker and blackjack in college, so I know that feeling. I know that rush of seeing good things happen and the despair when bad things happen (all too well), so I’m familiar with that mentality. I don’t gamble much anymore but it’s easy for one to fall into the trap of playing a little too much with the investment portfolio. So many of the same features of the stock market mimic the casino. Your money isn’t “real” money, it’s just numbers on a screen. Stock prices can jump and fall so quickly (even more quickly once you start talking options and derivatives) that it can give you that rush. (I wouldn’t recommend for gambling addicts!)

The solution is to go “Regular Joe” (i.e. Lazy) on 90% of your portfolio and allow yourself to “play” with the remaining 10% (any safe percentage, or absolute number, will do). With the 10% you can put it on individual stocks, experiment with options or futures or even foreign exchange, and feed desire for excitement.

The Compulsive Ticker Checker

When I first started working, I checked Yahoo! Finance every half hour while I was at work. I had some individual stocks in my Roth IRA and I was checking them every few minutes just to see what was going on. I did it because I didn’t really have much else to do at the time and it was just a way for me to read up on news, check to see if anything crazy was happening, and otherwise just kill time. The real solution to a compulsive ticker checker, if you want to reduce risk and still maintain market returns, is to select broad market index funds and add them to your online portfolio tracker. You’ll have plenty of information in those index fund news articles to keep you busy all day. Or get a hobby that isn’t investment related!

The Overworked

If you’re the type of person who wishes there were twenty-eight hours in a day, then you know that the reason your investments are being neglected is because you simply have too much on your plate. Rather than adjust your life’s priorities so you can invest properly, you should adjust your investments to match your life’s priorities. If you’re way too busy to look at your investments, even just once a year, then go with entirely lifecycle or target retirement funds. They are simply mutual funds comprised of other mutual funds, designed for a specific retirement date in mind. They handle all the allocations, all the re-balancing, and all the headache you simply don’t have the time to do yourself. They are also very affordable so you aren’t paying out the nose for someone to manage your investments.

Selecting the right style is crucial to ensuring long term success. If you’re a gambler (or have the itch of a gambler) and try to stick with a portfolio that doesn’t let you satisfy your desire for risk, you’ll end up making bad decisions somewhere once those bottled emotions get uncorked. If you’re overworked and don’t stick with something simple, things will fall through the cracks and your assets will suffer.

Which type(s) are you?

(photo: spencereholtaway)

In the Summer 2008 issue of In The Vanguard, a newsletter The Vanguard Group sends out to its customers, the newsletter interviews two outgoing managers of their Wellesley Income Fund: Earl McEvoy and Jack Ryan. Both have years and years of experience in investing, managing several other funds, and the interview was enlightening.

Here’s my favorite question and its answer by Ryan (the whole interview):

There’s an old blessing (or curse), “May you live in interesting times.” You’ve guided your funds through some very interesting times. Which stand out?

Mr. Ryan: I think we’ve always lived in interesting times. For example, if you think back to the 1970s, before we were Vanguard portfolio managers, we had a major banking crisis. New York City was going bankrupt. Consolidated Edison cut its dividend—and electric utilities had never cut dividends. We had a recession, and the rise of the “Nifty Fifty” stocks. So we’ve always had interesting times. What’s different today, perhaps, is that there is more financial news coverage, which can make the situation of the moment feel very intense. (emphasis mine)

It’s interesting Ryan says that because its something I’ve come to learn after reading of the turbulence in the 70s and 80s. I’ve been listening to Alan Greenspan’s Age of Turbulence and things, at least numerically, seemed far worse in prior eras. We cry about a 20% drop since the highs of last October, but on Black Monday, October 19, 1987, the stock market fell 22.6% (508 points!). We talk about foreclosures, job losses, and inflation… all of which were far worse in previous bad economic times but the US economy endured. In the S&L crisis, 747 banks failed!

The sky isn’t falling, things aren’t that bad, we just live in interesting times and the media is making the most of it. Here’s what both managers believe is in store for the future, as well as some advice:

Economic news has been downbeat lately. What is your outlook for the U.S. economy?

Mr. McEvoy: With respect to the Federal Reserve, I think they are finally accomplishing the type of yield curve they want. If the Fed can keep short rates low, banks will be able to shore up their capital by borrowing short and lending a little bit longer. However, I don’t see how we avoid an increase in the inflation rate, which will put pressure on long-term bonds.

Mr. Ryan: The outlook is challenging, but if you’re thinking long-term, it’s an excellent opportunity to look for companies or mutual funds that are well-positioned for the future when the economy does recover. This is exactly when you want to increase your investment exposure.

The opportunities for investing are just as great today as ever. The world continues to develop. People want to do well. They want to grow their companies. They want to get ahead. There is a lot of wealth in the system that will be invested. The opportunities are there. It’s just a matter of studying, doing some work, trying to improve your judgment, and taking advantage of opportunities as they present themselves.

The Dow opened on January 2nd, 2008 at 13,261.82 and opened on July 1st, 2008 at 11,344.64 - for a spectacular fall of over 1,917 points. Don’t calculate the percentage, it’ll just make you throw up.


This week, a barrel of oil (NYMEX Sweet Crude) topped $145. A barrel of oil cost an average of $15.70 ten years ago (adjusted to 2007 dollars). I will be investing in a Flintstone-mobile. Here are the latest energy prices on Bloomberg. *sigh*


Can someone with better math, or better descriptive skills, explain why a 50% difference is only considered “slight?” We expected 40,000 fewer jobs in June, there are actually 62,000 fewer jobs… but it’s only slight. “Job losses in June were slightly worse than the 40,000 expected by economists surveyed…”


Starbucks to close 600 stores with 12,000 affected workers. Stockholders rejoice as SBUX jumped 4.6% and MBA professors sob as one of the most referenced marketing case studies gets a black eye. At least there’s always Southwest.



Royal Caribbean’s Project Genesis, a cruise ship yet to be named, will be the most expensive and largest cruise ship ever constructed and will cost a mere $1.24 billion dollars. It will carry 6,400 passengers, weight 220,000 gross registered tons, and displace more water than a Nimitz-class aircraft carrier. (it wasn’t announced this week, in fact it was announced over a year ago, but it was worth putting in this week just because!)

Have a great Fourth of July Weekend!

(I’m going to start doing Week in Numbers [WIN] every Friday afternoon, please let me know what you think!)

I’m clueless about a lot of things but the number one thing on my mind lately has been risk in investing. I don’t mean stock market investing or real estate investing, I meant the concept of investing and risk (specifically, determining and being paid for taking risk).

Most people associate investing with the stock market because that’s the easiest way to invest. The stock market is the perfect investment system in that your assets are pretty liquid and the barriers to entry are low. It’s absolutely free to open a brokerage account and trades are dirt cheap (cheapest is $0 a trade at Zecco, but that has gotten mixed reviews; second cheapest reputable brokerage is TradeKing). You can buy and sell stocks pretty easily as there is never a scramble to find interested parties, though the price you get may not be to your liking. You hope for good equity appreciation (increase in stock price) and perhaps take some cash flow along the way (dividends). The rate of return on the S&P has been around 10% for the last 80+ years.

Now take the second thing people associate with investing - real estate. In real estate, the assets aren’t as liquid (especially now!) and the barriers to entry are much higher. At best you have to come up with a downpayment and transaction costs (Realtor fees, lender fees) are high, fewer people get involved in real estate investing. (Over the next two weeks I’ll have four guest posts going over real estate written by Trisha Allen, a seasoned real estate investor, so if this is up your alley keep your ear to the grindstone) With real estate, again you hope for good equity appreciation (increase in home value) and perhaps some cash flow (rent) along the way. The rate of return on this has generally been about inflation (surprisingly) according to some experts (they could be wrong).

There are other means of investing (such as owning your own Rita’s Italian Ice!) but the gist is to put your hard earned money to work for you. However, how do you analyze risk?

Every risk analysis class I’ve taken, be in undergrad or for the MBA, has always explained the same thing. You take the severity of a bad event times the probability and that’s your risk. They never talk about how to guesstimate the severity or the probability, just that you multiply and some magic number comes out. Also, they never talk about how much of a payoff you should get for shouldering how much risk. Real estate seems riskier to me than the stock market (higher barriers, more money involved, more headache), yet the stock market has greater returns. One expects riskier investments to yield greater returns.

Anyway, that’s what I’m clueless about, how about you?

(Photo by Patrick Haney)

Last week I wrote about a little preview to the SmartMoney 2008 Broker Survey in which SmartMoney released some preliminary results from their annual ranking of brokerage firms. SmartMoney has published the full details of their report and I’m sad to say that TradeKing did not retain the top spot they enjoyed the last two years (third place isn’t bad!).

Summary

SmartMoney changed the way they listed their rankings a little this year. Last year, they separated “discount” and “premium” brokers. Compare the tables from 2007 versus the tables from 2008, they went from three (premium, full-service, discount) to one (umm… everything).

Of the 2008 top 5 (they were, in order, E*Trade, Fidelity, TradeKing, TDAmeritrade, Charles Schwab), only TradeKing came from the 2007 Discount Brokers bracket and they took the third spot (so one could argue they are still reigning champs of the Discount Broker conference?), the rest came from premium brokers.

The Winner: E*Trade

E*Trade snagged the top spot this year with nearly five stars across the board. They also shared a nod for the best trading tools with TD Ameritrade and topped the list for best banking services (sharing that one with no other brokerage). When you can offer an interest rate of 3.25% on your holdings and not require thousands and thousands in the bank, it’s no surprise they were given the nod there. I personally enjoy using E*Trade for my stock trading because of this convenient link between the bank and brokerage.

Incidentally, in 2003’s rankings, E*Trade scored 9th in the “basic discount broker” category because of their $22.99 a trade commissions. It’s amazing what five years and “listening to feedback” can do for you.

The Top 5

Looking strictly at stars, not much separated the top five. While the criteria were not equally weighted, each one scored five stars in at least two categories and a minimum of three stars in each (in fact, only TD Ameritrade had two three-star categories, every other broker had only one).
Here were the concerns (and my comments) about the top five:

1. E*Trade: None listed, they are so perfect.
2. Fidelity: Commissions were on the high side, at $10.95, I agree. Though I don’t really consider Fidelity a discount broker (in 2007, they were considered “premium”).
3. TradeKing: Weaker fund selection, though they were noted for low commissions ($4.95 a trade).
4. TD Ameritrade: No negatives listed, though they only gained three stars in banking services. Their interest rate on cash of 0.1% was the lowest of all the sixteen listed brokers by far (second lowest was #9 Scottrade at 0.5%)
5. Charles Schwab: Is Schwab really a discount broker? Commissions run $12.95 a pop, hardly “discount” prices, but they had only three-stars in customer service.

TradeKing: 2007’s #1 Discount Broker

They probably got hosed this year by the rejiggering of categories (they had to update their little award picture!) since they were the only one of the top five to have come from last year’s discount category. Of the top ten, they were the second cheapest to Interactive Brokers (a firm I hadn’t heard of before this year’s survey) by a significant margin (after TradeKing, second cheapest was Firstrade at $6.95, a 40% difference). TradeKing did score a ribbon for best customer service and were the only firm to earn five stars in that category.

Zecco: 14th of 16th - Ouch!

What about #14 Zecco with their free trades? (they get a lot of blog press) They scored very weakly across the board for each of the five categories (one star in Trading Tools, Research, and Customer Service) though they received special citation for the worst customer service of the bunch. The $0 per trade offer is a compelling offer but if you’re looking for some hand holding, you won’t get it. Tou get what you pay for ($0). If you only need a broker to enter your trade into the market, Zecco is a good deal; if you’ll ever need to talk to someone about anything… you might as well slide up the commission price chain and go with someone like #6 Firstrade ($6.95 a trade) or #3 TradeKing ($4.95 a trade). You shouldn’t be trading so much that much anyway (though Sharebuilder, the epitomy of buy and hold, took dead last).

There you have it, another year, another brokerage survey from SmartMoney. If you’re looking for a bank and brokerage in one, I personally recommend E*Trade because they make it easy to link up the two (open up one account and you can open the other within minutes online), which can be a good or a bad thing.

Source: SmartMoney’s Annual Broker Survey [SmartMoney]

If you know nothing about the stock market, consider yourself lucky.

If you think the stock market is a scary place that you don’t understand, you’re actually in good shape.

I learned about the stock market in a time of prosperity, in pieces, and probably in the worst possible way and it’s burned me on numerous occasions. When everything is going up and there’s an irrational exuberance, you are afforded the opportunity to have good results come out of bad decisions and that can lead to the development of bad habits. So, if you know nothing about the stock market and are scared of it, that’s actually the best time to start learning about it.

So, if you’re scared and I have bad habits, why should you read anything I have to say about investing? I don’t actually talk much about investing outside of discussing ideas and theories (and recommending index funds from Vanguard) but today I’ll outline a few good resources I’ve found to help you learn more about investing in the stock market.

Morningstar Investing Classroom

The number one best place to start, if you know absolutely nothing, is with Morningstar’s Investing Classroom. They have four areas of beginner study - Stocks, Funds, Portfolio and Bonds. Each classroom has five levels of study with the exception of Bonds, it only has two, and each level has anywhere from five to eleven courses. I’ve taken several of the courses and they begin with the basics and move onto progressively more advanced topics.

As a bonus, you earn points for answering the quizzes following each course and can redeem those points for various rewards (you have to be a free registered member to earn these credits).

Motley Fool’s Investing Basics

If you’ve completed all of Morningstar’s Investing Classroom courses, Motley Fool’s Investing Basics is a great place to reinforce those ideas but with a witty and humorous twist. Depending on how quickly you went through the Morningstar site, you probably glossed over a few topics or forgotten others, so review can’t hurt. Plus they’re entertaining to read.

Decisions Decisions Decisions…

At this point, armed with the basics, you have to make a decision. Do you want to invest the your stock allocation in index/mutual funds or do you want to try to go your own way and invest in individual stocks? If the answer is index and mutual funds, you probably are armed with enough information go forth and conquer. Open an account with a Vanguard or a Fidelity and have it (those two always seem to dominate Top Fund lists). If you want to go after individual stocks… there is more learning ahead. (some would say there is more to learn but from here but between Morningstar and Fool, you have enough information to Google search from here)

Securities and Exchange Commission

The SEC has a great guide to financial statements, which you’re going to have to decipher and interpret if you hope to be able to pick some winners in the stock market. I would also get myself familiar with EDGAR, which is the SEC’s database of company filings (EDGAR Quick Guide, Comprehensive EDGAR Guide). EDGAR is far more versatile (and comprehensive) than navigating company websites for their filings. They also have a pretty extensive Publications section that has all sorts of valuable information.

Google Finance

If you want a very quick snapshot of a particular company, I think Google Finance has the most amount of information on a single page and provides the easiest interface to reach it. Simply type in the ticker or name of the company and you can get a wealth of information on one page. You can access their related companies, their latest financials, recent and future events, key stats & ratios, a brief summary as well as links on their company website, list of officers and directors, as well as links to other resource reports such as SEC filings, MSN Money’s listed major holders, etc. All that information is one page, that’s why I like it over other similar services like Yahoo Finance (Yahoo Finance’s advantage is that you can add a lot of technical indicators to their charting services).

Wall Street Journal Markets Data Center

So, armed with that information, you probably have enough to go out and do some serious damage to your portfolio (take that any way you’d like :)). Are you ready to be inundated with market data? If so, and my inundated I mean like drinking from a fire hose, then check out the Wall Street Journal Markets Data Center. Pages and pages and pages of financial information at your finger tips. (if it’s intimidating, but that’s okay… and that’s just the home page, you can drill down even more!) It’s absolutely stunning… now go forth and conquer!

Money Magazine recently released the only 7 investments you’ll ever need and, surprise surprise, my favorite firm, Vanguard, was listed first choice for five of the seven. Their founder, John Bogle, was a major proponent of index funds and it shows in their offering, as almost all of Money’s choices were low-expense ratio index funds.

Need another reason to have a mutual fund account at Vanguard? (No, Vanguard doesn’t sponsor this site!)

Blue-chip US-stock fund: Fidelity Spartan 500 Index (FSMKX) because it replicates the S&P 500 with an expense ratio of 0.10% (coincidentally, Vanguard’s version, the Vanguard 500 Index Fund Investor Shares (VFINX) is 50% more expensive with a ratio of 0.15%).

Blue-chip foreign-stock fund: Vanguard Total International Stock Index (VGTSX) because of its solid performance, beating 90% of its peers, and because it’s an index fund with an expense ratio of 0.27%. Another Vanguard fund, the Vanguard FTSE All World Ex-U.S. ETF (VEU), was listed as an alternative.

Small-company fund: T. Rowe Price New Horizons (PRNHX) is an actively managed fund, one of the few actively managed funds they selected, and is “one of the most efficient of the actively managed crowd.” Considering it is actively managed, an expense ratio of 0.8% is pretty good, about half the average.

Value fund: Oh look, another Vanguard fund - the Vanguard Value Index (VIVAX) and its 0.2% expense ratio and a record that trumps 78% of its peers. Value funds go after investments that appear overlooked or beaten down and try earn a little off those cigar butts and dividends, rather than looking for growth potential.

High-quality bond fund: Vanguard Total Bond Market Index (VBMFX) snags this category with a 0.2% expense ratio. Bonds are good to be the rock in your portfolio to give you some grounding as your other investments shoot up and crash down.

Inflation-protected bond fund: This last category was won by Vanguard’s Inflation-Protected Securities Fund (VIPSX) and it’s 0.2% expense ratio (Vanguard’s index funds are ridiculously efficient). “Among TIPS funds, Vanguard Inflation-Protected Securities has several things going for it, including lower costs and better management than you would get if you assembled your own TIPS portfolio. While the fund returned 6.6% over the past five years, you shouldn’t expect it to make a pile of dough. Its job is to protect the money you already have.”

Risk is a word that gets thrown around often, especially when referring to the stock market. Experts talk of the dangers of investing in the market and the dangers of not investing in the market. They talk about how you need to take on an acceptable level of risk for your tolerance and how you need to mitigate your desire for fantastic returns by taking on a reasonable level of risk. Risk sounds so risky! So, what are all of these risks and how can you mitigate them? That’s what I sought to finally understand and this is what I learned.

There are a lot of fancy names for risk but the bottom line is that understanding them gives you a better chance are being able to mitigate their effects. You can’t fully reduce risk but through proper diversification, you can reduce their effects on your total portfolio so there isn’t one silver bullet that can take you down.

First, let’s talk about the differences between systematic and unsystematic risk. Systematic risk also known as undiversifiable risk refers to risk that affects an entire market or market category, such as market risk. Short of investing abroad or hedging your bets, you can’t get away from market risk. Unsystematic risk is also known as specific risk and refers to events that affect a small number of stocks, such as the risk of a strike or poor management decisions. You can reduce unsystematic risk by properly diversifying your holdings.

Market Risk

Market risk refers to the risk you take on as a result of investing in a particular market, in my case it would be the United States. Market risk refers to the idea that if the overall market falls, perhaps in response to Fed actions on interest rates, rising costs of oil, etc., then your investment may slide along with every other stock.

To mitigate market risk, you have to diversify your holdings such that you’re not entirely committed to one particular market. An easy example is to diversify your holdings through the purchase of ADRs or emerging/developing/international stocks. In mitigating domestic market risk, you introduce several other risks such as the foreign country’s market risk (known as country risk) and currency risk (impact of the change in exchange rate between the dollar and the foreign currency). However, since you’re diversified, the effect of each of those risks is lowered.

Inflation Risk

Inflation risk refers to the risk you take by not investing your money, stock market brokers love this risk :). Inflation, which most rules of thumb peg at around 3-4% a year, erodes the purchasing power of your money every single year. If you don’t get 3-4% annual returns on your dollar, you’re effectively losing that money each and every year.

You mitigate inflation risk by investing your funds, but this naturally introduces a whole hosts of other risks. The only difference here is that inflation risk is a near certainty - inflation doesn’t roll the dice to see if she’ll erode your money this year, she always takes it.

Manager Risk

Manager risk, or management risk, refers specifically to the risk that your mutual fund, or the company you’ve invested in, will suffer as a result of ineffective, poor, or under-performing management. It essentially points to the fact that the company or fund may be sound but the management made bad decisions that cause the stock price or fund price to suffer.

This is difficult to mitigate outside of diversifying your assets because you often won’t see anything that could clue you in. Oftentimes, managers simply make bad decisions or bad bets and it’s nothing intentional. You don’t see many Enrons and, even if you did, there are no obvious signals warning you that something is foul. Simply do your research and be confident that the manager of the fund you’re interested in has a long, strong and solid history of performance.

A close relative of manager risk is active risk, which refers to the risk associated with a manager of a mutual fund trying to beat his or her benchmark. Active refers to actively trading, or active mutual fund (vs. passive index mutual fund), and it’s been shown that the more active the fund, the more divergent it will be with respect to returns vs. its benchmark. Sometimes you beat the benchmark, sometimes you don’t, that’s active risk.

All Other Risks

There are plenty of other risks out there with fancy names like Political Risk (effect of political instability or changes in a foreign country), Liquidity Risk (lack of demand for your investment might make it difficult to sell), Reinvestment Risk (you can’t reinvest your funds at the same rate, or at all), etc. but I felt that those big ones were the only ones worth focusing on at this point. There are a lot of risk terms out there that can get as specific or as general as you could ever possibly want, but understanding market, inflation, and manager risk is usually sufficient for most purposes.