Chapter 2. RISK AND REWARD

Financial planners tell stories about people who hesitate to invest in the stock market because they fear risk. There are widows who fear that a stock crash could leave them destitute. There are young couples who pine for a new home but worry that an investment loss could kill their chances. And there are people who want to avoid the devastation their parents or grandparents experienced after the 1929 market crash.

Often, however, these fears are rooted in a misunderstanding of what risk is when it comes to the financial markets. Those who understand market risks—and properly evaluate their ability to tolerate them—can supercharge their investment portfolios by embracing a certain amount of uncertainty and getting rewarded for it.

UNDERSTANDING MARKET RISKS

James P. King, a financial planner from Walnut Creek, California, illustrates this point with a riddle: Consider two investments. With the first, you are guaranteed to lose money. Invest $1,000, and you'll lose $1,000. The other could allow you to cash out with an amount ranging from $0 to $5,000 on your $1,000 investment. Which is riskier?

Many individuals would say the riskier investment is the first, because their principal would be in greater jeopardy. But to financial professionals, the first investment is merely stupid—not risky— because it's a sure thing to lose.

In the financial world, risk translates to uncertainty. It's measured by "standard deviation from the norm"—in other words, it's measured ...

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