The following article originally appeared in Fidelity’s magazine for 401(k) investors. I am adapting it to reflect my views and advice.

Introduction

Risk is a central element of investing in any financial instrument, from high-growth stocks to U.S. Treasury bills. So, a thorough understanding of its various forms is critical to making any sound investment decision. But just as important is understanding that, try as you might, you can never avoid risk altogether. Even cash in a CD or savings account is not without risk (see “inflation risk” below).

Since risk cannot be eliminated, investors need to manage it. By diversifying investments, appropriately allocating assets, and establishing prudent financial plans, investors can develop risk-control strategies that match their own unique circumstances.

The following glossary identifies some key risks to consider.

Market risk is the risk that the value of an investment will drop due to a change in general market conditions. Also known as “systematic risk”, market risk is not driven by issues unique to any particular investment. Rather, market risk stems from changes in the economy, or from war or other broad, market-moving factors. Unlike many other forms of risk, market risk is unaffected by diversification. In fact, market risk is what remains after a portfolio has been fully diversified.

While market risk never disappears, investor perception of it can vary widely, depending on recent experience. From 1992 to 1999, people got more and more aggressive, because they actually believed there was no market risk. Whatever they bought went up. How could that be risky? Of course, since 2000, the market has shown again just how risky it can be.

Sector risk is the risk that a particular sector will underperform the overall market. A good example of this risk is the technology sector’s performance in 2000. Of course, sector risk can be mitigated by investing in broadly diversified mutual funds.

The simplest means of diversification is to invest in one market index fund such as the Total Market Index that mimics the Wilshire 5000. Other ways to broadly diversify is to buy funds based on styles and market capitalization. In this way, an investor could buy a large-cap growth fund, a large-cap value fund, a small-cap growth fund and a small-cap value fund.

Company risk is the risk that a company will not perform as expected. Perhaps earnings won’t meet projections or a planned merger will not go through. Any one of an infinite array of company-specific expectations can be dashed at any time. Again, diversifying by investing in mutual funds can offset this risk.

Fund manager risk is the risk that an actively managed mutual fund will underperform funds with similar objectives. Hot mutual funds can turn cold for a number of reasons. Hot funds tend to attract more cash than the fund manager can effectively deploy.

There’s also the powerful tendency called “reversion to the mean.” Top mutual funds for one period (say over 5 or 10 years) tend not to perform as well in the following period. Fund manager risk can be eliminated by choosing low-cost index funds.

Market-timing risk is the risk of underperforming a buy-and-hold strategy. Investors who employ wholesale market-timing attempt to exit prior to a bear market and jump back in when they anticipate a bull market.

One reason market-timing is so difficult is that bear markets sometimes end with powerful upward moves. For example, in August 1982 the Dow experienced a whopping 11.5 percent explosion. Then there’s August 1984 when the blue-chip index had an impressive leap of 9.8 percent. Both surges signaled the end of bear markets.

However, if you embark on timing the market, do so in moderation. Jack Bogle, while strongly cautions against market-timing, allows the use of “tactical asset allocation” for investors. Assuming an investor has set a strategic asset allocation, a tactical asset allocation change of up to 15 percent is within reason.

For example, an investor may have a strategic asset allocation of 60% stocks and 40% fixed income. Sensing an approaching market decline, an investor might shift his allocation to 45% stocks and 55% fixed income.

Interest rate risk is the risk that interest rates will change and therefore affect the value of an investment. Let’s first look at interest rate risk as it applies to bonds. Suppose one day you purchase a bond with a fixed rate of 6%, the market rate that day. Now suppose that on the next day, market rates for bonds like yours rise to 8%. Suddenly, investors won’t be willing to pay full price for your low-yielding bond. On the other hand, if market rates fall to 4% the next day, investors may be willing to pay a premium for the above-market rate on your bond.

High interest rates can adversely affect the economy. High interest rates makes borrowing money more costly for companies and consumers. Higher borrowing costs may increase a company’s expenses and reduce its profit. When consumers use debt to finance purchases, higher interest rates may curtail spending. Finally, high interest rates may draw investors out of stocks for more attractive returns on fixed income investments.

Inflation risk, also known as purchasing power risk, is the risk that inflation (rising prices for goods and services) will erode the value of an investment. For example, if you make a one-year investment that yields 2% after tax and inflation is 3%, then the real after-tax return of your one-year investment is actually negative 1%. That is, you will be able to buy less with your money at the end of the year than at the beginning of the year.

Shortfall risk is the risk that a portfolio does not meet an investor’s financial needs. Here, the emphasis should be on planning for short-term, medium-term and long-term goals. Keeping sufficient ready cash to cover unplanned events and emergencies is a prudent short-term goal.

For medium-term and long-term goals, investors should budget an amount specifically for events that will require outlays in the future. If you know you’ve got a child that’s going to be starting college in three years, you could be better off investing those funds more conservatively than you would funds that you won’t need for another 25 years.

Emotional risk is the risk that an investment decision is affected by emotional factors.

Greed and fear are the number one and two motivators. During bull markets, greed can become a primary motivator. Similarly, fear can become a primary motivator during bear markets. Both greed and fear can lead to poor decisions, such as leaving a mutual fund to bet it all on a hot stock or leaving the stock market altogether for the perceived safety of CDs.

Another dangerous emotional pair are pride and regret. Too often, people confuse luck with brilliance. Pride can then cause people to be overconfident and make stupid mistakes with their investments.

But regret can be even more perilous than pride. People will remember a bad decision and be paralyzed by it much longer than they will be energized by a good decision. The key is finding systems that help you overcome making emotional decisions to begin with.

One such system is creating a document called an Investment Policy Statement. “Put it in writing.” That’s the advice from Charles Ellis, author of Winning the Loser’s Game.

Take the time to articulate your investment strategy. Assess how you reacted to adverse market conditions. Then form your plan for asset allocation and diversification.

Once you’ve written up your investment policy, show it to your closest family member and your best friend. If you’re ever tempted to alter your policy statement, tell them first. If they both protest, think hard before changing anything.

Conclusion

In sum, not all risks are created equal. And not all can be managed in the same way. But with an awareness of the potential outcomes of your investments and the various catalysts behind them, you may be better equipped to make informed decisions. And just as important as understanding your investments is understanding yourself and your tolerance for risk. You’ve got to be comfortable with what you do.

In the end, after all the analysis and soul searching are done and all the preparations and allocations are made, you will still be left with the uncomfortable fact that you are unable to predict the future. So, alas, you are unable to avoid risk. But, you can manage it.