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April 21, 2011

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I also don't like the word "Gamble" in this context.
If a person wants to gamble they should go to Vegas and have some fun at the same time.

Investing in the stock and bond markets certainly has its risks but you are free to sell any of your holdings at any time. The intelligent approach is to devise a way whereby you can limit your risks. The key to lowering risk is to lower volatility. However, in general, the lower the volatility - the lower the return.

The key is therefore to select investments that you are comfortable holding. Every person has a different tolerance for risk. For example I'm risk averse, my sport is hiking. My son, on the other hand, has been a dare devil surfer, a lover of very fast boats, fast women, a parachute jumper, and a race car driver. Fortunately he came through with nothing worse than a cut that took 100 stitches to close, but now that he's 47 and a Dad he doesn't do anything dangerous.

A measure of volatility that I like to use is called the "Maximum Drawdown" or MDD.
To calculate it, let's say over a 6 month period, you need to know what the worst loss would have been if you had bought on the day during that period that the issue had the highest value, and that you sold on the day it had the lowest value. Why it's such a good measure is that in practice, on the very day that an issue is at its lowest value you have no idea whether it's going to recover or whether it's going to continue to decline. That's when you may be experiencing a gut wrenching pain and don't know whether to continue to hold or to just get out. What the issue has done in the past is about all you have to go on.

Here are two examples for the time period of the current year.
FSICX - Fidelity Strategic Income ......... ANN=11.71% .... MDD=-0.45%
FSELX - Fidelity Select Electronics ...... ANN=37.17% .... MDD=-12.19%

In this case FSICX gave you a nice smooth ride with a small worst drawdown.
FSELX however gave you 3.17 times the return but its worst drawdown was 27 times greater.

At age 76 you don't have to ask which one I would prefer, especially if I had a huge amount of money in it. (BTW I don't own either one)

Umm this must be a really old rule from the depression.

Diversification may reduce your potential risk, but there is still risk, especially the way the market has trended the last 10 years...

What we saw in 2008 is the more traditional asset classes that used to provide a high level of diversification become highly correlated (move together). In other words, almost everything lost money.

As we move forward in our investing, I think it is important from a risk management point of view to integrate asset classes that are truly less correlated to one another to include non traditional asset classes.

Derrik Hubbard, CFP

I agree with the bit of advice about not investing money in individual stocks you can't afford to lose. The only time I invest in single stocks is when I use small amounts of money (what I call "play money") that I would not miss too much. For the rest, I employ a mix of index mutual funds and ETFs with Vanguard.

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