How to Manage Stock Market Risk: A Practical Guide for Every Investor

Every investment involves risk. The goal isn't to avoid risk entirely — without it there would be no long-term reward — but to take the right amount of risk for your goals and to avoid risks that don't pay you anything in return.

The Main Types of Stock Market Risk

• Market risk: The whole market falls, as in a bear market. Diversification within stocks can't eliminate it.
• Company-specific risk: One business fails or disappoints. Diversification largely eliminates this.
• Concentration risk: Too much money in one stock, sector or theme.
• Interest rate and inflation risk: Changes in rates or prices affect valuations. See how inflation affects stocks.
• Liquidity risk: Being forced to sell at a bad time because you need cash.
• Behavioral risk: Your own emotions — panic selling or chasing hype. For many people this is the biggest risk of all.

Know Your Risk Tolerance and Risk Capacity

Risk tolerance is how much volatility you can stomach emotionally. Risk capacity is how much loss your finances can actually absorb, which depends on your income, savings and time horizon. A 25-year-old saving for retirement has high capacity; someone retiring next year has much less. Your portfolio should respect the lower of the two.

Seven Proven Ways to Manage Risk

1. Build an emergency fund first. Three to six months of expenses in cash means you'll never have to sell stocks in a downturn. See why an emergency fund comes before investing.
2. Choose an asset allocation. Your mix of stocks, bonds and cash is the biggest driver of your portfolio's ups and downs.
3. Diversify. Spread stock holdings across sectors, company sizes and geographies — our diversified portfolio guide shows how.
4. Limit position sizes. Many investors cap any single stock at around 5% of their portfolio.
5. Rebalance regularly. Bring your allocation back to target once or twice a year. See our rebalancing guide.
6. Invest gradually. Dollar-cost averaging reduces the risk of investing everything at a peak.
7. Avoid leverage. Margin loans and leveraged products magnify losses and can force sales at the worst time.

Matching Risk to Time Horizon

Money you'll need within about three to five years generally doesn't belong in stocks, because a bear market could hit just when you need it. Money for goals decades away can usually tolerate a much higher stock allocation, because time has historically allowed markets to recover.

Stop-Losses: Useful or Not?

Stop-loss orders automatically sell a stock if it falls to a set price. They can limit losses on individual positions, especially for traders, but in volatile markets they can also sell you out right before a rebound. For long-term index investors, asset allocation is usually a better risk tool.

Managing the Biggest Risk: Yourself

• Write down your investment plan and the reasons for it.
• Check your portfolio less often during turbulent markets.
• Automate contributions so decisions aren't made in the heat of the moment.
• Remember that volatility is the price of admission for long-term stock returns.

The SEC's Investor.gov offers free tools for assessing your risk tolerance.

Key Takeaways

• Risk can't be eliminated, but it can be managed.
• An emergency fund, asset allocation and diversification are the foundations.
• Match risk to your time horizon and capacity, not just your feelings.
• Your own behavior is often the biggest risk to your returns.