Risk Management Solutions In Investing

by KenFaulkenberry

in Risk

Risk Management Solutions

Risk Management Solutions

Investors lose out in investing because they fail to implement risk management solutions. The average investor underperforms the average investment because they don’t understand risk. I’m going to describe how to lay a foundation to cause the odds of winning to be heavily in your favor.

This approach will greatly improve the long term probability of outperforming instead of underperforming the market. However, it’s hard to get excited about implementing risk management solutions without first recognizing the importance.

Warren Buffett did not say “Rule #1: Never Lose Money; Rule #2: Never Forget Rule #1” just because he didn’t enjoy losing money. He understands the disastrous consequences of losing your principle. The laws of compounding make large portfolio drawdowns unacceptable.

If You Lose:

Gain Required to Break Even:

5%

5%

10%

11%

15%

18%

20%

25%

25%

33%

30%

43%

35%

54%

40%

67%

45%

82%

50%

100%

75%

300%

90%

900%

If you have a gain of 50% and a loss of 50% (it doesn’t matter in what order) you are not at break-even. You have lost 25% of your principle! The above chart displays the fact that if you lose 50% of your portfolio you must have a 100% gain to break-even.

The two major types of investment risk are market risk and specific risk (systematic and unsytematic risk ).

1. Market Risk (Systematic Risk)

The stock market moves up and down. The stock prices of companies can be grossly overvalued, greatly undervalued, or anywhere in between at any given time. Benjamin Graham demonstrated this phenomenon with a parable, Mr. Market and the Intellegent Investor. You might want to read this great perspective of market investment pricing.

Here are two indispensable risk management solutions for market risk.

Asset Allocation Planning

How can manage risk without identifying and quantifying potential risk? You can’t. Every investor should calculate their probable maximum loss and adjust their asset allocation accordingly.

Most investors invest too aggressively (greed) when valuations are high and too conservatively (fear) when bargains are available. Figuring out your probable maximum loss is an exercise that will make you think hard about how much risk to accept. This will cause you to adjust your asset allocation to better reflect long term goals.

Valuation Timing

Market timing for value investors is valuation timing. Part of the exercise of probable maximum loss is planning for opportunities. If you are going to have cash to take advantage of the market when it offers bargains you can’t be heavily invested when valuations are high.

Valuation timing means you own assets that offer a margin of safety. If you buy when prices are below their fundamental value you have room for errors, misjudgments, or unforeseen problems. When you buy at prices that are fully or over valued you are more likely to suffer large losses when something goes wrong.

2. Specific Risk (Unsystematic Risk)

Individual investments can increase or decrease in price without any correlation to the market. This is risk specific to the individual investment or small group of investments. Specific risk is risk that is distinct for that investment. Examples would be product risk, financing risk, legal risk, poor management decisions, etc.

Diversification

The good news is that specific risk is easy to mitigate in a portfolio. Investment diversification is frequently described as a “free lunch” because, done properly, it has the ability to lower risk without lowering expected returns.

If you only have one investment your portfolio risk would be extremely high. Your portfolio returns might be high or low, but would depend on one investment. However, if you own 15 – 30 investments you “smooth out” your returns. The variance (risk) of your portfolio returns will be reduced.

Investment Decisions Based On Valuation

The best risk management solution when buying individual investments is to pay a price below the real value of the asset. Investment decisions should be valuation based because the price you pay will be the biggest determinant of your return on investment.

You can buy great companies who perform just as you expect but lose money because the price you paid was too expensive. On the flip side, you can buy companies where unexpected problems arise but you make money because the price you paid provided a margin of safety.

Investing Using Risk Management Solutions

In summary, valuation is the key risk management solution in investing. Asset allocation planning and diversification are the two investing strategies that can reduce risk without sacrificing returns.

Don’t allow emotions and “herd mentality” to ruin your portfolio returns. Effective risk management solutions can be obtained through valuation based decisions in asset allocation planning and diversification of individual investments.

Related Reading: Perceived Risk vs. Real Risk: A Key to Successful Value Investing

Portfolio Risk Control Strategies – Focus On What You Can Control

Written by KenFaulkenberry

KenFaulkenberry

AAAMP Blog by Ken Faulkenberry
Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record.
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