At Invest in the Markets, we approach investing with three primary objectives: to protect capital, to minimize risk, and to maximize returns. As you’ll notice, two of the three are “defensive” in nature… which is what keeps our investors from experiencing huge declines in their portfolio’s value or sleepless nights due to market corrections. It’s not that we take out all the volatility and uncertainty out of trading; rather, we take advantage of upswings in the markets while reducing our positions when the markets dip down.
Today, we’ll take a moment to define “risk management” prior to discussing some common investing myths that devalue risk management. Then, in the following days, we’ll return to explore some practical steps investors can take to manage their assets. But before you read on, take a moment to enjoy this brief Seinfeld Risk Management clip.
Defining Risk Management
The textbook definition might read something like this: Risk Management is the process of identifying, assessing, and prioritizing the perilousness of the situation in order to be able to coordinate efforts to minimize, monitor, and control the impact of unpredictable events and maximize the results of opportunities (modified from Wikipedia). When we break this out, we notice a few key characteristics:
- An Acceptance of Uncertainty – Investing involves uncertainty… and if we’re unwilling to accept some inconsistencies, then we will be disappointed. But, if we can accept that uncertainty exists, then we’ll be better prepared to stop trying to predict market direction and focus more on preparing for market trend changes.
- An Ongoing Process – There are no books, computer programs with different coloured lights, nor advisors who can provide the ultimate trading system that will never need adjustment. Furthermore, just when we feel that we’ve prepared for the uncertainty, a new world event or market crisis will emerge, causing us to reevaluate our presuppositions.
- An Opportunity for Prosperity – As we accept the uncertainty and make adjustments to our plans, we learn to prosper in good and poor market conditions. We do this by protecting our capital, thus controlling the uncertainty, and by taking advantage of the market trend. With each moment of flux comes opportunity and risk management helps us identify these opportunities and take advantage of them.
Fear Controls Investors
Fear is real… especially among investors. And the older we get, the more likely investors will feel the impact of that fear in their investment portfolios… for our need to use our savings gets closer and our ability to generate new wealth diminishes with the years of our lives. That’s why most investors believe it is necessary to lower the amount of exposure to “risky” assets as they age. Personally, the categorization of “risky” assets is often misconstrued. Nevertheless, fear is a real and sometimes healthy emotion and it is particularly evident when things are not going well.
Investing Myths that Devalue Risk Management
Most investors and advisor will not come right out and denounce risk management. Yet, many devalue risk management by their very actions. They offer advice and defend it with shades of grey, often for their own good, not the good of the investor. Remember, many “professional” advisors make money based on the average investor keeping and adding to their investment portfolio. If they don’t have investors using their services, they don’t get paid. But I digress…
Here are some ways investors and advisors alike will sometimes denounce risk management indirectly:
- It’s Too Late to Sell – Have you ever owned a stock that has dropped significantly enough that you feel it is too late to sell? So, instead, you might even throw more money at it as it circles the drain… In fact, one of the main reasons investors lose money is because they chase losing stocks.
- Buy the Right Stock – Some investors believe if you simply buy the right stock, you’ll be fine. Often, they’ll use fundamental analysis to determine what stock is right for them. Let’s say you did just that… and determined that BP would be your stock of choice. So, in 2010, upon seeing some recovery in the stock, you purchase BP shares… and then it happens. The oil spill… cutting the stock price by 52% or more. Now, some people are quick to point out that if they simply bought then, it eventually climbed, at least a little. Well, then take Enron… or Oilexco… or… the list is endless.
- Dollar Cost Average – I suppose nothing more needs to be said with these past couple of examples. But, take away the doom and gloom stories and we are still left with the question, “Why invest in a stock that is dropping in value when we could be making money by investing in a stock that is rising in value?”
- Plan your Purchase, Not your Sale – Investors often put lots of effort into planning their purchases without any thought toward an exit strategy. Unfortunately, this effort on the front end without thought toward the last transaction can lead to unnecessary losses.
Join me in a couple of days when we’ll look at some specific ways investors can develop and apply risk management techniques in order to help you Preserve Capital, Minimize Risk, Maximize Returns. It’s not a hollow motto… it’s a statement of guiding principles at Invest in the Markets. It’s a commitment to an investment process that accepts and prepares for uncertainty while looking for opportunities. Most importantly, it’s an acknowledgement that risk management should guide every stock trade.