We usually think of investment performance as involving what sort of returns we can make or do make with them, and usually confine our concerns about risk to when things are going badly or very badly and the concerns that we should have been aware of have really come home to roost.
This usually means being long the stock market and seeing things turn sour on that side of the investments. We may have diluted our stock positions with other types of assets, usually bonds, and this does tend to water down both returns and risk, but the amount that we’ve left exposed to bear markets still bears the full brunt of whatever comes our way.
While diluting our positions, or hedging them as people often refer to this as, might be better than doing no hedging at all and going all in with stocks on the long side all the time, this does not mean that this is necessarily the best approach. If we convince ourselves that these are the only two reasonable options though and this passive hedging is the better of the two, that can indeed seem best.
We do need to protect ourselves from such things, not only when we don’t have the time to recover from them, but even if we do. Losses incurred from hanging on to investments in negative climates where the expectation of profit has been replaced with an expectation of losses cannot ever be recaptured, at least versus managing things better and avoiding a large part of these moves in flights to more safety.
There is no completely safe investment, and even keeping money in the bank risks bank failure and even deposit insurance may fail, as may governments themselves. Having deposit insurance does manage the risk of bank failure though, and it’s all about looking to manage these possibilities appropriately, which means a balanced approach to risk and returns.
We might still want to invest in something like junk bonds over higher grade ones to seek the higher returns that the lesser bonds may pay, but if we do, simply being willing to lose the money invested isn’t managing the risk, it is ignoring it or accepting it as it is. Managing risk means taking action to both avoid unacceptable risk and to also seek to reduce those risks that we can manage, like investing in low quality bonds but with one eye on the door should things not proceed well enough.
Risk with Investments is Both Variable and Dynamic
Let’s imagine we’re considering a given investment, and at the present time, we estimate the risk as being acceptable. Accepting risk and managing risk are, once again, two separate things, and both must be present. We must accept the risk that is there to make sense of taking it on and we also need to manage it to achieve our investment objectives without allowing it to become too high later.
Let’s say our investment later becomes riskier than it was when we first bought it. Investment outlooks do change over time, even though we often like to pretend that it doesn’t, and this is required to make sense out of a strategy that just ignores it after it is acquired. Both expected returns and risk can change over time in fact.
Just because we are hoping to hold something come hell or high water doesn’t mean that the hell or high water doesn’t matter. The changes that we see that may increase the risk of our investments may not even have anything to do with the investment itself, and most often isn’t, as macroeconomic factors drive the value of securities more than anything else.
When we see undesirable changes happen with our investments, we can either just ignore them or take action to look to manage the situation. This can involve anything from cutting back on our positions to liquidating them completely, depending on the situation.
Doing nothing should not even be in the conversation though when action is required or warranted, because this will just involve accepting whatever risks manifest and that’s just not a good way to manage one’s portfolio, in spite of how popular this might be among individual investors.
Taking a hands-off approach to investments involves us neglecting risk management completely and exposing ourselves to the full measure of whatever comes along, and some nasty things indeed can arise.
This approach is a lot like pointing your car down the highway and turning it over to the technology of the car, which might be fine in many situations but there will be things come up that require human intervention. If the road becomes slippery then we will need to adjust our driving accordingly, and even pull over if things get bad enough, but that won’t happen without our having our hands on the wheel and our feet on the pedals.
With our particular investment, we presumably had a positive expectation when we bought it, although this may or may not be the case in fact, and we don’t really pay much attention to this anyway. As time goes on though, whatever expectation it may have had is subject to change, and these things change quite often and sometimes quite dramatically at that.
If we choose not to adjust our expectations to bring them more in tune with the reality of the situation, we risk seeing losses pile up, and if we are living in a fairy tale world basically where everything just has a happy ending regardless of the trouble that may come along on the journey to this promised land, we’re apt to be disappointed and even hurt.
How Risk Management and Profit Optimization Differ
It’s the hurt part that risk management is concerned with, to look to minimize this. Proper risk management also tends to drive better returns, but that’s not the primary goal here, it is to minimize the risk of losses or drawdowns.
We usually don’t consider drawdowns when we consider risk, and are more concerned or even exclusively concerned with booked losses, which happen when we close our positions, but drawdown certainly matters as well.
Let’s say that our investment, which started out looking pretty good and doubled its price over a period of a few years, later lost half its value. We’re in the same position that we started basically, other than losing value to inflation. We can even take that out of the equation by saying that we’re in the same spot after adjusting for inflation.
We might have justified our staying in the position by hoping that things may turn around, and be shaken more and more as the position moves against us. We do need to understand that in this case it definitely does move against us because if it started at $100 and went to $200 then we need to judge it by where it moved from with the current trend and not the two combined.
This is because, when we don’t do this, we don’t protect the profits we have booked and we’re therefore willing to let them scatter in the wind should it blow the wrong way. This is drawdown risk, and the overall risk of the investment hasn’t hurt us because we haven’t lost anything but we sure have fallen a long way.
As it turns out though, managing overall risk of loss and managing drawdown risk cashes out to basically the same thing, as both require similar techniques. Protecting our initial capital and protecting our profits involve seeking to protect our account generally, where a certain threshold of risk will be set, and if we exceed this, we need to take action.
This should never be done in a static fashion, measuring our losses in reference to our entry point, it should instead be managing the risk of movements against us generally, involving what we could call dynamic risk management.
Protecting profits does tend to increase profits as well, and this is where there are similarities with seeking to optimize returns. In fact, managing risk properly and managing returns properly are in harmony generally.
We usually think of risk and return as being opposing forces, diametrical, and if we are speaking of inherent risk that part is usually the case. However, managing risk is different, taking whatever inherent risks that are there and seeking to reduce them, and as we do, we improve our returns as well.
How We May Manage Risk Dynamically
All we need to do in order to get the right mindset for proper risk management is to realize that risk really is a dynamic phenomenon and if we’re going to manage it, we need to adjust to changing conditions, changing amounts of risk.
Let’s say we bought our investment back in 2010 after all of the dust settled in the stock market from its crash and things started to look very bullish. It’s 2019 now and we’ve done very well. During this period, there really hasn’t been any market shocks of any consequence and this move has been virtually straight up, a very nice bull run indeed.
We’re not going to hope this continues forever, and we’ll say we still have another 20 years before we need this money, and what we end up with after all this time is going to matter. Managing risk means first and foremost defining it, which basically means that we’re going to need to set an amount of risk that we’re prepared to accept and no more.
With dynamic risk management this means defining the amount of drawdown that we’re prepared to accept, or rather, how much drawdown we’re able to withstand and still make holding our positions make sense.
If we don’t have a plan here, this means no risk management at all, and proper risk management is required if we want to be successful at investing. There will be certain circumstances that will trigger us to at least pull back, if not pull out, and pulling out is generally the better choice when things go south by a meaningful amount.
What this threshold is set at, our risk tolerance, may depend in part on our risk appetite, how much risk we’re comfortable with, but this cannot be the major and especially not the sole determining factor. Objective factors, which derive their power from probabilities, need to be the main thrust of our plan and our thresholds.
Since in this example we’re looking to hold positions longer term, and this is the case with most investors as well, we’re not going to sweat the smaller stuff, the usual ups and downs of the prices of investments, as this doesn’t represent enough risk to us to be that concerned with.
With the bigger things, we do need to take heed because this is the point where the risk of holding the investment is unacceptably high as we breach our threshold. It’s never about what has happened so far, the damage already done, it is instead about the damage that may come and may likely come.
If profit maximization is the offense of our portfolio, risk management is the defense, and we’re looking to use this only to defend, even though the best offense is often a good defense.
No professional trader would ever enter a trade without clearly defining their risk, and if they don’t, they risk financial ruin. Many less skilled traders pay attention to this but not enough and it is their undoing.
Risk is amplified to some degree with trading though due to the use of leverage and risk management is more important, but this doesn’t mean that this is not important to successful investing. This is especially true if one’s investing horizon is becoming close enough that the backup plan of waiting for things to come back may not have enough time to be reasonable or even possible.
Aside from hedge funds, who distinguish themselves from normal funds by actually playing an active role in managing risk, to some degree at least, risk management is virtually ignored in investing circles. We can really get a leg up by paying a lot more attention to risk when we invest.