Three Misconceptions About Risk Management

“Risk is the permanent loss of capital, never a number.” – James Montier

Risk management is something every investor realized they needed following the 2007-2009 financial crisis. The same thing will happen when the next bear market hits. But too many investors learn the wrong lessons or take misguided advice about how to approach risk. Here are three common misconceptions about risk management.

1. Managing risk requires figuring out exactly what’s going to happen in the future. There’s a debate amongst financial types about what constitutes forecasting. Is asset allocation considered forecasting? Isn’t everything technically a prediction? This debate gets bogged down in semantics. Intelligent investors understand the importance of planning for a wide range of outcomes by thinking in terms of probabilities, understanding that they will be wrong from time-to-time and the willingness to admit they can’t or don’t need to know everything. I subscribe to the Dean Mathey philosophy: “Be optimistic but always plan for the worst.”

2. Your risk appetite will remain static. Investment committees would benefit from a periodic risk assessment from an organization such as Riskalyze (something I actually suggested to them) just to show how often their perception of risk changes and/or evolves. The same is true for individuals. At times, life events — a new job, a new baby, a higher salary, a lower salary, a new house — will require a change in your risk profile. Other times the market’s movements will make it feel like you should be making changes to your portfolio. Often the feelings you get based on these factors will be the opposite of what you actually should do.

Your appetite for risk will likely ebb and flow with the markets even if your ability to take risk based on your financial situation hasn’t changed much. Investors should set up an investment plan accordingly to make sure they’re not always acting on these impulses.

3. A risk model will save you. GMO’s James Montier has a good quote on risk models:

The idea that if we can quantify risk then we can control it is one of the greatest fallacies of modern finance. VaR tells us how much you can expect to lose with a given probability, such as the maximum daily loss with a 95% probability.  Such risk management techniques are akin to buying a car with an airbag that is guaranteed to work unless you crash.

I don’t think that all forms of quantitative risk management are useless. In fact, risk models can be helpful to provide context and perspective. But the more confident investors are in a risk model’s saving power the more useless they become as they do a great job of telling you what’s happened in the past but a poor job of predicting what’s going to happen in the future. The best a risk model can do for the investor is point out where potential areas of risk exist, not how that risk will manifest and play out.

Source:
The Little Book of Behavioral Investing

Further Reading:
Risk Management Always Matters
Doubling Down on Risk

 

 

 
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  1. connecting.the.dots commented on Apr 15

    […] stocks are overvalued and 68% think the U.S. is the most expensive region.”  Meanwhile, “your appetite for risk will likely ebb and flow with the markets even if your ability to take risk based on your financial situation hasn’t […]

  2. Taking Stock commented on Apr 15

    To me, risk is permanent loss of purchasing power. Losing some portion of your money in the short term is inevitable unless you sit in cash. But sitting in cash is far riskier in the long term as it is not a prescription for financial well being and it will mean facing some difficult decisions both financially and lifestyle wise.

    • Ben commented on Apr 15

      I agree. Most investors have a hard time figuring out exactly what risk means to them and for many it changes depending on what’s happened recently. I always say the real biggest risk is running out of money before you die.

  3. Midweek quick links: 15 April 2015 | Dustin's Blog commented on Apr 15

    […] Three Misconceptions About Risk Management “The best a risk model can do for the investor is point out where potential areas of risk exist, not how that risk will manifest and play out.” […]

  4. Irondoor commented on Apr 16

    Risk is not meeting your objectives, whatever they are. The only problem with this is that often people have goals that can be difficult to reach without taking on more exposure to short-term market volatility than they may be comfortable with. An example is the investor who sold out of his equity position in early 2009 and never returned to the market. It is now likely he will not meet his former investment goal.

    • Ben commented on Apr 16

      Very true. It’s difficult to look beyond what’s happening right now to think about what really matters many years down the line. Daniel Kahneman has a great line where he says the long-term is not where life is lived.

  5. Beto commented on Apr 17

    Risk is probability x consequence