Risk and Diversification: What Is Risk?

In general, risk involves exposure to some type of danger that has the potential to cause loss or injury. In the investing world, it’s the chance an investment's actual return will be different than expected. This uncertainty includes the possibility of losing some – or all – of the original investment. (For more, see: 4 Steps to Building a Profitable Portfolio.)

Everyone is exposed to some type of risk every day – whether it’s from driving, walking down the street, investing or something else. Even if you sit on a couch all day in an attempt to avoid risks like getting hit by a car or catching a virus, you would still be exposed to the many risks associated with being sedentary – including anxiety, depression, cancer and cardiovascular diseases. Bottom line: No matter where you go and what you do, you’re exposed to various risks every day. (See also: What Kind of Securities Should a Risk-Averse Investor Buy?)

Your general risk level and your investment risk level

Your personality, lifestyle and age – among other factors – play a big role in how much risk you are comfortable with. Of the millions of surfers in the world, for example, only a tiny percentage ride the really big waves at breaks like Mavericks and Nazaré – it takes a special breed of risk-taker to surf a 60-foot wave, after all. While millions of surfers are comfortable riding “regular” waves, most draw the line when the waves get really big because the risks are too high.

Like surfers, each investor has a unique risk profile that determine their willingness and ability to withstand risk. In general, as investment risks rise, investors expect higher returns to compensate for taking those risks. As an investor, the key is to find a balance that lets you enjoy reasonable earnings while still being able to sleep at night. (See also: What is Your Risk Tolerance?)