Last week's blog on second order thinking was an introduction into how people beat the market. This week we are covering risk management and next time it will be "non-consensus" thinking. I think these two are the largest contributors to superior returns sometimes called edge or alpha.
Risk management might sound boring to some people - those people are wrong. Risk management is where grown up investing begins.
Risk management is not avoiding risk, quite the opposite. Think of risk management like the straps and padding in a racing car. Racing drivers take huge personal risks, and know that they are likely to crash a car one day. They want to be confident they can walk from that crash and go back into training. In investing it is being able to have an investment decision go badly and not experience significant financial loss.
Seth Klarman, a successful value investor who founded Baupost summed it up nicely "The best investors do not target return; they focus first on risk, and only then decide whether the projected return justifies taking each particular risk".
What is risk?
Risk according to dictionaries is some variant of exposure to danger, but is used so widely and in so many investment contexts that it is difficult to pin it down. From my experience I would say there are three main uses of the word risk in investing:
The tendency of the price to move around a lot. The price movement can be very high in risky stocks, or very low in terms of US government bills.
The chance that you have a permanent loss of your investment (more frequently considered by bond investors)
The chance that your investment portfolio does not meet your target return.
All of these make sense, but I feel we are shoe-horning a lot of uncertainty into a very tight definition and miss a lot. Given identifying and managing risk is so important I think it is worth us breaking risk down into the type of uncertainties we face in investing. (This framework was borrowed from Warren Black who I recommend you follow on LinkedIn).
The 5 building blocks of uncertainty and risk
There are many possible outcomes: Think of this as rolling a die where any of 6 outcomes are possible and you cannot remove that risk.
It is a complex system: Some outcomes have so many variables and complex interactions that it is impossible to predict for certain something like the weather in a month's time.
Unknown knowns: We know what something is, but do not know enough about it to understand how it really works. For example during the early parts of COVID, there were knowledge gaps into what this disease was, how it spread and so on. These gaps increased uncertainty.
Unknown unknowns: Things we have not considered as a possibility. We probably do not know all the species of deep sea life yet would not be able to predict which species we have not seen yet.
Moral unknowns: How might the world react to this from an ethical perspective? An example would be the ethical impacts of rolling out gene-editing to the world.
Each of these sources of uncertainty introduce more variable outcomes to your portfolio. A summary table for your reference below.
So how do we manage risk?
The risk management mindset, understands that there are a wide range of outcomes and that things will often not go to plan. That humility allows for much more nimble risk-taking. Additionally not all risks can be captured accurately within models, and many cannot be captured at all. Too much false comfort has been provided by models.
The following principles are how some of the best money managers that I have had access to over the years have managed their risk (and you should incorporate in your portfolio). I have split them into fundamentals and pro-tips:
Fundamentals
Understand your investing style: Each person has a unique willingness to see their portfolio go up and down in price and time horizon they like to invest for. Your first lesson as an investor is to know what you are comfortable with and put together your portfolio appropriately. Whilst I prefer long term holds, some people prefer shorter term trading for at least a part of their portfolio. Choosing a style that does not work for you will lead to investment errors later down the line.
Size your positions right: Your investments should be sized to avoid a large proportion of your portfolio to be lost if a single investment idea did not work out. You should consider sizing not only on an individual investment but also on the type of investment. If all your stocks are in semi-conductor manufacturers they will all move in line with each other and so large losses (and gains) are more likely. Even your highest conviction bets should have a position size limit.
Spread the risk: Include a number of themes in your portfolio that do not move too closely with one another. This will allow a number of good ideas into your portfolio where hopefully on average you will gain even if one or two themes do not move as you expect.
Change your mind: Over time decisions may work out just as expected, but other times it diverges from what you expected. It is hard to go against an earlier decisions, it makes us feel like we have lost. However, sticking with a losing trade is one of the most common ways that investors lose a large amount of money. A couple of tools investors use to help them get over this inertia are:
Pro-tips
Use a margin of safety: You are never going to perfectly forecast. Allow for some deviation. A great investment (which happens rarely) can withstand a significant downside from expectations and still be a good investment.
Limit leverage: Don't borrow too much against your investment. In spread betting accounts, overuse of leverage is one of the quickest and easiest ways to lose money.
Look at downside mitigation: Large losses can be avoided by having the right insurance, by buying options or by getting involved in asset-heavy companies that can be sold in the event of a bad scenario.
So what?
Risk management is a crucial aspect of investment (and life) and an essential part of investing. Rathe than being dull, it helps investors feel confident to take the right amount of risk.
Risk not only encompasses volatility and potential loss, but a range of uncertainties including many outcomes, complexity, unknowns and ethics.
Risk management takes self-awareness, managing concentrations and humility and can be enhanced by allowing for a margin of safety, minimal use of leverage and use of options which protect downside risk.
Thank you for joining. "What is alpha and how do people generate it" next week. Sign up to the subscription list on Blog | Deciders (hartejsingh.com). Follow me on twitter: @Decidersblog
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