Managing Your Investment Risk

The Myths of the Passive Approach to Risk

Just about every investor and just about everyone that advises people on investing believe that the most conservative approach to investing is simply holding investments over the long term with no regard to managing risk at all.

It is common in fact to see any deviations from such a plan as being seen as riskier or even considerably riskier than just holding on to your investments and standing pat. People will say things like you shouldn’t be gambling with your retirement money and such whenever people consider anything else but putting all your money on the line in these unmanaged positions.

This extends, and perhaps especially extends to those who wish to look to time their investments beyond just hanging on to the like you are supposed to. While we may want to be concerned with investments that may be more speculative in nature than our main investments, whether or not this applies to looking to manage risk with our main positions needs to be more a matter of discussion and examination.

This starts with looking at how well a passive approach manages risk, and then and only then can we make sensible comparisons of risk with other strategies. Just how well does the buy and hold approach manage risk anyway?

It turns out that it doesn’t manage it at all, because nothing at all is being managed with this strategy, we’re just allowing ourselves to be subject to whatever amount of risk the market casts upon us.

What Managing Risk Actually Involves

Risk doesn’t mean a specific instance of drawdown, that’s drawdown itself, and risk means the potential for certain amounts of drawdown in our portfolios. In order to assess this potential, we look upon the past, just like we do so in order to get an idea of what sort of return we might expect.

Risk and return are opposite phenomena, where the potential for return concerns itself with expectations of profit, and risk deals with potential losses. The difference here is that returns are more concerned with where we will end up, and risk deals with how far down we may drop along the way as well as where we may end up,

When you are in a position, it does matter how much you are up or down at any given time, even when you are not looking to sell, and while a lot of people focus too much on this, being in a situation where you have watched a big percentage of your value go away is going to matter and certainly will bother people.

Risk is also directed at the potential for actual losses, where we sell the position at a certain loss, and this is where most of the focus is on, because this involves real money being lost and not just paper losses. We can’t just focus on this though, because where our portfolio goes along the way, especially how low it goes, matters as well, especially if we may be prone to jumping ship at the wrong time if things get bad enough.

Risk management involves our using loss controls to in some way seek to mitigate risk by setting conditions whereby we will limit it in some way, in order to prevent us from taking on the full amount of the risk that may manifest itself. In terms of trading stocks, this involves setting limits on how far down the value of our stock portfolio is allowed to decline, whether this be by way of dollar or percentage limits, or by some other means of measuring the market to determine how unfavorable conditions may become.

We also need to assess the potential for risk in an investment, where in this case we’d be looking at the past to determine whether stock markets decline enough to make this all worth worrying about. They certainly do, and all investors need to manage risk, and they will understand this at some level, even though they have been conditioned to either ignore it or pay less heed to it than they should.

It is actually pretty amazing how so many investors just ignore investment risk or just throw a certain portion of their portfolio in something else like bonds and feel that they are not only protected but sufficiently protected against risk, while at the same time crossing their fingers every step of the way and becoming quite concerned indeed when the feared bear market starts to show its ugly face.

How to Manage Investment Risk

If we’re concerned about a bear market and just sit idly by when we do experience significant drops in the valuation of our portfolios, if we are concerned about risk but not really doing anything about it in terms of looking to manage it, there is a real disconnect here to be sure.

The real disconnect here is with wanting to limit one’s investment risk and actually knowing how to do this effectively or even attempt to do so effectively. We are told all the time that we cannot time markets effectively, in order to discourage us from attempting, and most investors don’t even have enough knowledge to realize that this view is mistaken in fact.

In order to pull this off though you do need to have a certain amount of knowledge, which starts with the fact that this is not really difficult at all to do, and then coming to realize just how one approaches this successfully.

This is what investment manages is essentially, managing your positions dynamically in accordance with the market. When we buy an investment, we do so with a positive expectation, and while this expectation may be over the long term, it still is influenced by market factors along the way.

Managing this involves us looking to only be in an investment when it has a positive expectation, and while we will never be able to achieve the ideal here due to the market being only somewhat predictable, there are clear instances where the outlook over a certain time is not positive at all.

In these situations, the risk of losses increase, and if we’re looking to manage our risks, which doesn’t mean ridding ourself of risks but limiting them, this is going to involve decisions about whether we want to be in these investments during these times of poor performance or the likelihood of it.

We Just Need to Beat a Random Distribution to Benefit Here

As for how difficult risk management of investment portfolios actually is, this is just a matter of being right more than we are wrong. If someone had absolutely no knowledge or skill, and did not pay attention to the market either, we would expect that the net result of timing decisions would be flat and the only negative would be trading costs, which for investors is pretty minimal.

If, for instance, we held our positions for a certain number of predetermined years, let’s say 5 years in and 5 years sitting flat or in something else, none of this corresponds to real world conditions and we would expect that this would be a neutral strategy, much like just holding for the entire 10 years would be.

From here, when we add in data that is concerned with market performance, this data will add to the likelihood of our being right, and according to the extent of the advantage this data or strategy bestows, this will both increase our returns and reduce our risk exposure.

If markets were actually random, like some academics believe, then all decisions would be neutral, including ones that seek to just buy and hold, as there would be no mathematical advantage in investing in anything.

This is clearly not the case though, and we do know that there are patterns to the price fluctuations of securities, for instance the tendency for the prices of stocks to increase significantly more than the rate of inflation, and also move in distinct patters over other periods of time to certain degrees.

Among these patterns are movements to the downside over extended periods of time which we call bear markets, and it is these movements that we seek to control our losses with when investing.

How We Might Mess This Up

Since there are patterns here that indicate momentum, it is certainly possible to go beyond random entries and exits and actually make mistakes with the timing of our investments. An example of this would be to enter after a very long bull market and hang on through a fairly long bull one.

We can also do the opposite and exit after a significant bear market and not enter once it turns around, and perhaps enter after a lot of the rebound has taken place. If our decisions are not in accordance with the momentum of the market, then we are certainly apt to screwing this all up.

It is the good decisions that are rewarded here, and the foolish ones often will get punished. It is the fear of this that has many investors extremely reluctant to try their hand at timing their investments, and if one approached this without a sensible plan, that should be a legitimate concern indeed and one would in fact be well advised to refrain here.

While a major goal of market timing is to limit risk, we could say that poor trading is a risk in itself and a fairly big one, if it adds to the amount of risk we’re taking on with the decisions that we make.

In order to overcome this issue, we need to realize that if we’re looking to limit risk we actually need to be focused on doing exactly that. In the case where we have entered a bull market very late, we’re going to need to protect ourselves from pullbacks, and even be more focused on this if anything.

Once the bull market ends, we simply need to be out, and whether we entered at the bottom or the top doesn’t really matter at all as far as risk management goes. Risk management concerns managing the amount of drawdown, not protecting profits, although we would be more poorly situated if we entered at the top rather than the bottom to be sure.

There really isn’t a difference between how we would manage these two scenarios, as any good method of managing risk is going to focus on the performance of the market itself and not our entries, which are meaningless actually, and in this case we’d be focused on the prospects of the bull market ending and the beginning of a bear market, which all takes place independent of our positions.

We do need to come up with a good plan as far as our deciding where we want to enter and exit, where we’ll be relying on good data to base these decisions on, and providing we can do that, which isn’t that difficult at all, we can both manage risk actively as well as looking to increase overall returns.

This should in fact always be our goal when investing, not being just content to do nothing and hope luck smiles on us favorably enough and bad luck stays away too much. Investing should never be about luck, but instead flow from reasoned decisions, provided we have the courage and foresight to pursue all this.

Andrew Liu

Editor, MarketReview.com

Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.