In our last article, we talked about the role of asset allocation in an investment plan. The topic this time is minimizing risk. It's a RISKY topic but let's start by stating the obvious, most people overly focus on returns and not enough on risk.
Returns are fun to think about and investors often start counting their rewards while still in the process of making an investment despite significant uncertainty. Wall Street relies on this tendency to sell all kinds of investments to a variety of people. Unfortunately, far fewer people pay adequate attention to the RISK that comes with their potential investments.
Remember that investing involves probabilities, not certainties, so risk comes with the territory. The best investors excel at managing risk, often more than they focus on calculating their potential returns. This focus on risk is a key difference between savvy investors and average investors. It explains much of the edge enjoyed by the former group.
By now, you may be asking, What is risk? Is there a good definition? That is an extremely important question. Most people would give you an intuitive feel for what it means, so they use the word casually. Perhaps a good functional definition is that investment risk is the possibility of losing some or all of your original investment, and secondarily as the possibility that you will not actually achieve the returns that you expect.
There are different types of investment risk. People may think of risk homogenously, but actually there are multiple identifiable risks associated with most investments. For example, there is inflation risk, principal risk, interest-rate risk, market risk, credit risk, liquidity risk, and volatility risk. A definition of each is beyond our current discussion.
What most people care and worry about, however, is the risk of losing their hard-earned money. Nevertheless, they often don't pay enough attention to managing this risk either intelligently or in advance. Most people do not do a good job of managing the risks associated with their investments. It happens through a combination of ignorance, lack of time, and also for psychological reasons.
The psychologists have extensively documented that we are hard-wired to be biased against losses, i.e. for most people the pain of a loss is a far more powerful emotion than an equivalent but opposite gain. This psychological principle partly explains why most people pay insufficient attention to risk & it is unpleasant to think about potential losses.
The other reason is that we tend to be irrationally optimistic that our own results will somehow be better than either probability or the experiences of your neighbors would suggest. Due to this overconfidence bias, people often make investments that they should probably be avoiding entirely. And of course, it is hard or impossible for most individuals to be objective about themselves.
These observations come from a field called behavioral economics which gives a lot of answers about why we do the things we do, including take risks even when they don't make sense and are likely to hurt us. The first step to salvation is to be aware that we have a tendency to think this way and use this awareness to step back or else rely on an advisor to do this for you.
Given this, you may be wondering whether and how investors can better manage investment risk? Note that the question implies that a person is aware of the risk and can assess it accurately, and as we have already noted, that is probably one of the biggest issues for many people in terms of the risks associated with their investments. A potential investor may be not be in the right frame of mind or have the time to recognize certain risks upfront. In most such instances, they will eventually realize it, but often once it too late to do anything to mitigate it.
Assuming the ideal case, however, in which risk is recognized upfront, the major ways to deal with risk are #1.) Avoid It; #2.) Hedge It; #3.) Insure Against It; and #4) Diversify. All four can be good tools to deal with risk if used properly. They can also be dangerous when misapplied. You probably use all of these techniques in your everyday life, though perhaps not as systematically in your investments. It is neither desirable nor really possible to avoid all risk all of the time. Certain risks, such as inflation risk will find you, even if you hide all your money under a mattress.
The most powerful technique to manage risk in investments is to avoid or minimize it up front. You or your advisor can do this by being selective and limiting your investment activities mainly to areas of special competence when you have an informational and experiential edge. By following this rule, you will be more likely to recognize risks involved and therefore accept risk knowingly and in exchange for returns that you can confidently predict in exchange for assuming those risks.
Most good investors and good business persons control risk in this manner, i.e. by limiting their investments to areas in which they have some special competence and confident based on logic that the odds of a good result are high. They also tend to avoid risks altogether that don't meet the above definition. This is why good investing has been called business-like investing, because it requires taking only calculated risks at opportune times to be adequately rewarded.
Diversification and hedging can be valuable techniques to further manage risks that cannot be avoided upfront. Diversification involves spreading out your assets and investments in multiple different places based on the idea that if bad things happen, it should not affect all your various investments in the same way. This is indeed a sound principle.
As far a hedging is concerned, there are several techniques like options, shorting, or buying negatively correlated stocks. Remember that hedging is like insurance in the sense that you are paying someone else to assume part of the risk. If you use hedging or insurance techniques such as options, it is likely to have a cost in terms of lower returns over the long-term in exchange for fewer fluctuations and protection again the big unexpected loss.
There may be an optimal level of diversification and/or hedging within certain ranges. However, each situation and expert opinions vary, so you or a competent advisor should customize an approach that fits your situation and tolerance. Note that it is also possible to be over-diversified when you don't really know what you are investing in. Just going for quantity or excessive diversification can guarantee a mediocre or worse return. An optimal level of diversification for most individuals can probably be achieved in an investment account with as few as 15 to 30 well chosen positions as long as there is an adequate emphasis on diversification by industry and some other metrics.
Pay attention to risk going forward and either take the time and effort yourself to intelligently manage risk or else seek out an advisor who has the expertise and time to help you assess and avoid investment risks upfront. It does not do any good to only realize you have an issue after it is too late.
As Warren Buffett says, "its only when the tide goes out that you see who has been swimming naked." Take a proactive approach so that you do not get caught unaware the next time the tide goes out. You will sleep easier and get a better result for yourself and your family in the long run. As doctors like to say - an ounce of prevention is worth a pound of cure.