Market Price Risk

All securities markets consist of the buying and selling of many individual securities. Yet individual securities often add or lose value parallel to theprice changes of similar securities. The tendency of individual securityprices to move together makes it valid to talk of a market advance or decline. The possibility of a market decline is an investor’s market pricerisk.

Analysts have tracked changes in market prices for many decades and this has led to a practical strategy for reducing market risk. Often, stockmarket prices have moved in different directions than bond and other fixed- income securities prices. Therefore, all types of securities are not likely todecline in price at the same time. You can protect your overall portfoliovalue by investing in a mix of securities types. This technique is known as”diversification.”Although diversification does limit risk, it also limits your potential for gains.

Consider what would happen in a rising stock market. You would gain themost with 100% of your portfolio invested in stocks. If you have limited yourrisk by diversifying your assets among stocks and other types of securities, only the stock portion of your portfolio would advance in relation to the stock market, and your overall gain would be lower. To best control yourrisk, you need to allocate your assets in a way that offers the possibility of making good gains if any one of the asset classes increases in value.

Industry And Company Performance Risk

Any specific investment also has performance risk. With a stockinvestment, the company’s stock price may decline, or stock prices in the company’s industry may decline generally. No one can tell future securitiesprices in advance, but some investments are less risky because they are higher in quality. A large and long-established manufacturer’s stock, forexample, is less likely to lose value than the stock of a small company with a new product. On the other hand, when such risky new companies do succeed,their stock often makes larger gains than the stocks of larger companies.

An effective strategy to limit performance risk uses market research to find high-quality companies and stocks that may make extraordinary gains.

You can also limit performance risk by diversifying your portfolio among different individual securities or investment funds. With a mix of securities,you are less likely to lose heavily if a particular security loses value.

Inflation Risk

There is a real risk that a future decline in the purchasing power of the dollar may whittle away at the value of your investment assets. Even periods oflower inflation can greatly erode the dollar’s worth if they continue for many years. To counter this risk, you need investment returns that exceed therate of inflation. But the investments that offer the best chance of higherreturns are usually the most risky. Again, you need to balance the possiblegains against the accompanying risk.

Interest Rate Risk

The history of securities prices has shown that when interest rates rise, the prices for fixed-rate securities, such as bonds and preferred stocks, tend to fall. And prices rise when interest rates fall. The possible loss in the valueof fixed-rate securities is known as “interest rate risk.” The market valueof existing fixed-rate securities also depends somewhat on the remaining term to maturity. By altering the term to maturity of your fixed-incomeinvestments, you can counter their interest rate risk.

The strategies that can control your investment risk are relatively simple, but it can be difficult to apply them consistently without cutting off your chances of profit. It may be to your benefit to consult an advisor who isexperienced in limiting risk while preserving possibilities of making gains.

ALAN S. MOORE, who writes this column every Wednesday for L’Observateur,is a financial advisor of Legg Mason Wood Walker Inc., a diversified financialservices and securities brokerage firm that is a member of the New York Stock Exchange and SIPC.

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