NEW YORK (CNN/Money) - Gauging risk is a lot tougher than most investors think. The problem is that there are really several different types of risk, and most market analysis focuses on the least important -- volatility.
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But temporary price fluctuations don't mean much. What really matters is the average growth rate a stock achieves over long stretches of time.
Consider the case of Applied Materials, the world's leading maker of semiconductor manufacturing equipment. The company dominates its industry, but business is highly erratic, because it's closely tied to the ups and downs of the cyclical semiconductor business. As a result, Applied Materials' share price has suffered massive declines -- 60 percent or more -- four times in the past 10 years.
Yet despite that volatility, Applied Materials has enjoyed enough boom years over the past decade to provide an excellent average total return -- more than 20 percent at a compound annual rate. And that figure is even more impressive when you consider that the stock has recently been trading far below its historic highs.
In a well-balanced portfolio, you can afford to own a few stocks that provide above-average total returns but move like yo-yos. Smart diversification will reduce the impact of sharp price swings on the part of one or two stocks.
If volatility is not as dangerous as investors are led to believe, then what should you be concerned about? In fact, the real risks are those that could prevent you from reaching your ultimate financial goals. Three of these dangers can be especially damaging:
Multibillion-dollar corporations usually recover from even serious setbacks. But that's not necessarily true for small growth companies. Not many of the dot-coms that were crushed during the past five years have fully recovered. And it may be impossible to make up for the impact big losses have on your long-term return, even over a 20-year period.
At the opposite end of the scale, being too cautious can reduce your investment returns so much that it's impossible to reach your long-term goals. For example, if you keep all your 401(k) money in short-term income investments, your balance will never decline. But you'll probably end up with less than a quarter of what you could have earned with a diverse assortment of blue-chip stocks.
Failing to keep up with inflation
It doesn't matter what nominal return you get if consumer prices soar even faster and erode your purchasing power. That's why electric utilities often turn out to be better long-term income investments than bonds. Even though the utilities may pay less today, their dividends grow over time, unlike the interest payments on bonds, which are most vulnerable to higher inflation and rising interest rates.
If you avoid these significant risks instead of worrying about daily price swings, you'll have a much better chance of beating the market in the long run and ultimately hitting your financial targets.