by Mike Finley

for Ebert & Sebastian

In the volatile investment world, safety is a constant issue. Hardly a day goes by that someone that doesn't offer you a risk-free investment. But the truth is, there's no such thing as a completely safe investment. And the reason is that risk takes many forms.

Market risk. This is the risk that most so-called "risk-free" investments offer to protect you from. It includes all the factors that, taken together, can drive down prices on the stock market. Political developments, changes in tax law, the "mood" of the market on any given day -- these are all things unrelated to a stock's fundamental worth which nevertheless can affect its value.

A great example was the 150-point drop on the DJIA last month, the week that Iraq invaded Kuwait and camped out on the Saudi Arabian border. Overnight the entire atmosphere on Wall Street went from blasé to fearful. Even if you held stock in a company that did no business in the Middle East, or that was far removed from the direct give-and-take of oil prices, like Mcdonalds your stock price went down. Mcdonalds dropped over __ points.

Economic risk. Here's another risk that stock investors inevitably assume. In a rising economy, stock prices generally rise; in a sluggish or depressed economy, prices fall. In a growing economy, investment dollars are plentiful; in a shrinking economy, money is tight. This is one reason analysts pore over the various economic indicators when they come out -- to gauge what effect they will have on stock prices.

The stocks most vulnerable to economic risk, of course, are the cyclical companies, those whose fortunes are tied directly to the expansion/contraction cycle. Cars, big-ticket consumer products, luxuries, chemicals, and travel are heavily cyclical. The stock prices of companies selling things people buy even when times get tough, like utilities, food, and energy, hold up.

Stocks are not the only investment vulnerable to economic risk. Bonds can also suffer, especially lower-grade bonds whose companies have to pay back high premiums, at a time when sales may decline. That is why analysts say that junk bonds might be an acceptable risk in a healthy economy, but can see wholesale defaults -- and principle wipeout -- in a recession.

Inflation risk. If your investments are returning 10%, that's great news -- unless inflation is occurring at 15%. Then whatever gains you thought you were getting are actually losses of 5%.

With the rise in energy prices because of the crisis in the Middle East, our economy is bracing for a significant wave of inflation. The stock market has already lost value because of market risk -- if you weren't in the stock market, you now face the second part of this one-two punch, as inflation gobbles up gains in the low-yielding money markets, short-term bonds,

Inflation is the most important yardstick any investment can be measured at. Think of inflation as termites, eating away at your wallet. If your wallet contains $1,000 in cash, and inflation proceeds at a conservative rate of 5% annually, after five years your purchasing power has dropped to $81.

And 5% is about what inflation has averaged over the past 50 years. Bonds haven't topped that. Government securities, touted as the "safest investments in the world," can't touch it. "Safe" passbook savings accounts and CD's certainly haven't. Only the stock market has outperformed inflation over that period -- while exposing investors to its own shorter-term risks!

Interest-rate risk. Rises in interest rates is poison to the bond market. If you buy a bond paying 8%, and newly issued, similarly rated bonds start paying 10%, no one will want your bond, so its price naturally decreases. To make matters worse, interest-rate risk hurts stocks as well -- a dividend of 4.5% starts to look unappealing when bond rates start to climb. Wall Street thrives on a free flow of money for margin account borrowers -- as rates rise, investors and traders alike borrow less impulsively, effectively capping short-term gains.

A variation on interest-rate risk happens when there is good interest rate news. It is called reinvestment risk, and it happens when interest rates begin to dip. Just as you are poised to take advantage of increases in your 30-year bonds, their issuer calls them, and you are forced to settle for their worth today, and not tomorrow. Or your CD matures, and you are forced to take yesterday's high-yielding principle and reinvest it at today's lower rates. Just as the train is gaining speed, you are bumped off.

Finally there is specific risk, also known as event risk. This risk covers all the terrible things that might occur solely to the company you just invested in. If it's a gold mine, it runs out of gold. Your corporate headquarters burns to the ground, as happened to Norwest Bancorp several years ago. The CEO, who has held the company together for years, dies, as happened this year at Campbell Soup. Your unions go on strike, and your company never recovers (Eastern Airlines). Your main customer cancels critical contracts with you (General Dynamics). Even bonds are subject to specific risk, as when a Aaa bond is downgraded to Bbb overnight following an LBO.

There are thousands of things which can go wrong to your company -- whether it is your company's fault or whether the fates are just out to get it, the net result is usually the same -- plummeting share price.

So, with all these risks, you're probably leaning toward stuffing your money in a mattress (don't -- see inflation risk, above). A more successful approach is to do several things:

Match risks with your risk tolerance, and with your objectives. If you are young and investing for the long term, market risk can easily be absorbed. Over time, despite its little upheavals, history shows that the stock market does rise. If your investment horizon is shorter, you should reduce your exposure to market risk.

Diversify. You can avoid the full brunt of specific risk by investing in a variety of companies. They can't all be hit by lightning. If you live in the Midwest, or work for an electronics firm, invest outside that area or industry. If you buy bonds, buy several different bonds.

Allocate your assets flexibly. Think of your portfolio as a river that is never the same from day to day. If interest rates are rising, decrease your exposure in long bonds and invest in shorter bonds, or the cash market. American stocks may look great one year, while European stocks may overtake them the year after. Pay attention to the markets, and try to be where the best opportunities are, and the risks are most manageable, for you.