If your investment loses value while similar investments gain value, then you are a victim of unsystematic risk. This type of risk can be mitigated through diversification. If your portfolio is properly diversified, then a loss in one position due to unsystematic risk will be offset by gains in other positions.
For an investor with a small portfolio, diversification can be provided through mutual funds, exchanged traded funds, or various other pooled investments. For an investor with a larger portfolio, diversification can best be accomplished by carefully chosen individual holdings.
If your investments lose value because of a general decrease in the value of all similar investments, then you are a victim of systematic risk. In years 2000, 2001, and 2002 the share prices of many U.S. technology stocks fell in value - this was an example of systematic risk in the technology industry.
Systematic risk can be controlled using asset allocation, or with a market neutral strategy or various other forms of hedging. More information is available in the "strategies" section of this website.
At IAM, we find that the best way to determine a client's risk tolerance is to thoroughly understand their investment needs and goals. For example, a retired person may be a daredevil in real life but if they are dependent on their portfolio for income, then their investment risk tolerance may be quite small. In fact, the level of risk an investor may be willing to take may not appropriately reflect his or her financial situation.
Before giving advice on investment matters, we ensure that we have an in-depth understanding of your situation. An analysis of how your portfolio would have performed historically over various difficult investment periods is performed so that you are aware of the amount of financial risk to which you would have historically been subject. Although historical returns may be quite different from future returns, at least this method can serve as a starting point for risk management.
An investor whose portfolio consists of shares in 100 different technology companies is probably not as well diversified as someone who holds shares in only 10 companies, each in a different industry group. A properly diversified portfolio is diversified regionally and in terms of asset classes and industry groups.
Useful diversification depends upon the lack of correlation between the returns on your holdings. You always want to hold investments whose returns will be positive in the long run, but you will have a less volatile portfolio if the returns on investments in one part of your portfolio outperform at a time when another part of your portfolio lags.
As part of our research at IAM, we measure the historical correlation between various investments and help control risk by choosing holdings that we expect will have attractive returns but that are not well-correlated. Furthermore, since correlations can change with time, we monitor our clients' holdings so as to ensure their portfolios remain well-diversified.