Before jumping into the water as an active investor, it’s a good idea to know how to swim.

Likewise, as an investor, it’s important to lay the groundwork before diving into the investment pool. In future blogs we will examine key investment areas such as asset allocation, diversification, liquidity, and risk/tolerance. But as we approach the “ins and outs” of actually investing, it’s important to see how these areas tie together and how “risk” (very often used as a broad term to explain a fundamental risk) can be broken down into various types of risks while building your portfolio. A good investment strategy begins with managing away, as best you can, several types of risk; three types of risk we'll cover today and three we'll cover tomorrow.

Fundamental Risk

Fundamental risk, or business risk, is often (combined with technical risk) the primary risk referred to when risk is discussed. Fundamental risk applies to bonds, stocks, real estate, and all investments. It is the risk inherent within a particular business enterprise that relates to the company’s financial strains, their position in the marketplace, their reputation, how they fare against their competition, and so on. It is more than the risk graded in the bond market, known as credit risk, which is more “black and white,” determining the likelihood of the company defaulting or not. The fundamental risk is affected by how well-managed the company is and how they fare in their market.

The best way to manage your portfolio to minimize the effects of fundamental risk is to diversify. This is where you are investing in different companies in different industries within the same asset class.

Technical Risk

Technical risk involves measuring things such as unemployment, interest rates, the budget deficit, and various other economic and market indicators. All of these external factors play a part in the success or failure of your investment. Technical risk, also known as market risk, is how well the market of your investment fares in regard to these factors. The affects on the overall market will affect your investment—which brings us back to the all ships rise or sink with the tide analogy.

Managing technical risk means having a balanced portfolio. This is another way of diversifying across asset groups by having your dollars allocated into stocks, bonds, real estate, money market funds, CDs, and so on. Different asset classes also exist within the same market. Beyond that, there are numerous markets and they will react differently to the economic indicators listed here. Even in the bond market, there are different classes of fixed asset investments including long-term bonds, short-term bonds, high yield or junk bonds, municipal bonds, government bonds, global bonds, and so on.

Investors can work on the 93 percent of the investment puzzle by focusing on the area of asset allocation and then look at the “7 percent solution” by focusing on the specific investments. In other words, if you plan to spread your money across various markets and asset classes, you can lessen technical or market risk before focusing on the specific investments within each group.

Interest Rate Risk

Interest rate risk, which I'll also discuss in future blogs on bonds, is how your investment is responding to the direction in which the interest rate is heading and how fast the rate is going. Often people assume that this only affects the bond market. Not true. There actually is a strong correlation between interest rate risk and the stock market. While stocks have various other factors that directly affect them, they will frequently follow suit with bonds and react in the same inverse manner to the direction in which the interest rate moves.

You can manage away interest rate risk by having part of your portfolio in fixed principal investments (bonds) with a guaranteed interest rate. Also, having a portion of your portfolio leaning toward short-term bonds (rather than long-term bonds, which will fluctuate more) will help you better avoid interest rate risk.

We'll take a further look at investment risk tomorrow.