Risk management is a topic we hear a lot about when it comes to investing. Its popularity tends to ebb and flow based on recent market performance. This seems intuitive to me because when the risk we’re trying to manage doesn’t occur, risk management often looks like a sunk cost. Conversely, when a risk we were neglecting occurs, we love playing Monday morning quarterback. If this sounds wrong, trust me, it isn’t. This is natural human behavior described aptly by Morgan Housel: “You will likely be more fearful when your investments are crashing and more greedy when they’re surging than you anticipate. And most of us won’t believe it until it happens.”
In the real world, there isn’t a risk management alarm that goes off before market events to let us know what to do. For most investors, this means practicing forms of risk management regardless of the market environment. As Ben Carlson once wrote, “Risk management isn’t something you can just turn on and off when you feel like it. Risk is ever present in the markets.”
Risk management is not about achieving the highest possible rate of return. It’s about making sure you’re capable of collecting the returns you need to achieve your goals. Staying in the game is more important than finishing first. With that being said, I think a lot of things get done in the name of “risk management” that don’t actually deserve the title. There’s a fine line between managing risk and destroying your ability to earn returns.
Risk management done poorly ends up looking more like return management. Here are a few examples:
Risk management: Owning a diversified stock mutual fund or ETF to manage single company risk
Return management: Owning 30 different mutual funds and ETFs with overlapping exposures to “diversify”
Risk management: Systematically using a trend following approach in your portfolio
Return management: Selling out of the market every time it dips 5%
Risk management: Regularly dollar cost averaging into your investment portfolio to minimize regret and timing risk
Return management: Stockpiling cash while relying upon intuition to identify the best time to buy
Risk management: Determining a sensible asset allocation based on goals, time horizon, and an overall financial plan
Return management: Tinkering with your asset allocation in response to market headlines
Risk management: Periodically rebalancing your portfolio back to its target asset allocation when it drifts too far
Return management: Placing daily trades in an attempt to outsmart the market and other investors
Risk management: Diversifying your exposure to different investment strategies because they will all spend time performing well/poorly over time
Return management: Strategy hopping in an effort to always be all-in on “what’s working”
Risk management: Realizing that the simplest way to hedge an unpalatable investment risk is to not take it in the first place
Return management: Falling victim to the siren song of risk-free returns in its various formats
Nobody can tell us in advance when we’ll need to manage risk or even what risks will need managing. The important thing for us to realize as investors is that this is okay. We cannot possibly hedge out all of the risks involved with investing. There are no returns without risk. Risk management isn’t about maximizing returns; it’s about not destroying them, while living to see another day.
I apologize for my lack of ‘Top Links’ so far this week. I have been under the weather with these strange shifts in temperature here in New Jersey. In my absence, however, I was able to stock pile a handful of really amazing articles. Take a look!