Most Investors are NOT bought into the true value of Risk Management (especially those who are only in the first decade of their journey).
Perhaps the 2nd word, "management" raises skepticism around Active Management (often equated with undeserved fee leaches).
To others, it's the word "risk" that sets them off. Many investors hold the (false) belief that Risk and Return are inseparable. Viewed through that context any risk reduction achieved must mean less reward.
My own experience (and that of thousands of well researched whitepapers) prove that effective Risk Management does not have to be a return crushing activity.
Risk Management isn't a "buzz word" or "business speak."
It has the power to change your life (after all, you need life changing wealth to retire off of passive income).
To that end, Risk Management is a skill that should be: Respected... Understood... and most importantly implemented with discipline (either by yourself or via a trusted advisor).
Risk Management is Investing.
Don't forget, Investing is a process. Profits and Loses are the result. Those who excel at the process earn their result from those who do not.
Their is a classic trader's proverb that sums this up...
Profits don't require management, losses do. The Profits will manage themselves --provided you manage the risk.
To use a lending analogy...
Anyone can lend out money, real investors possess the skill of getting it back (with interest)!
The Risk Management Process in Four Steps
The general process should work something like this:
Step 1: Determine your Risk Budget
Your risk budget should be lower than your Risk Tolerance. Having a budget ensures you don't "overspend" and get in physical or psychological hole because of it. Setting your Risk Budget properly helps you remain in a healthy state to follow your plan or make rational cases to amend it. Don't have a Risk Budget? Start off by measuring the risks you have already been taking and determining if you are under or over budget. Both can be damaging to your wealth accumulation. We cover several ways of measuring/thinking about risk in our other content. You can also send us a question or request to chat via our contact form here. It is always eye opening to explore the risks investors unconsciously accepted before they embrace Risk Management in their portfolio(s).
Step 2: Optimize for Risk Adjusted Returns
The goal here is to achieve the highest return per unit risk. The ratio is what is important.
Once you know how to manage risk, you quickly realize when both have the same probability:
Win $2, Lose $1 is a better trade than Win $3 Lose $2.
All of the novice investors are myopically focused on the wins. Everyone piles into the "win $3 trade "while the professional risk manager backs the truck up on the less crowded "win $2" trade.
But wait, if you stop at this step, you might have to accept lower returns for smoother a smoother ride. This phenomena helps perpetuate the illusion of the risk vs. reward trade off. However, the seasoned Risk Manager has another hidden lever. It turns out, risk management isn't just for peace of mind... it can dramatically increase your return potential.
Step 3: Adjust Your Exposure to Match Your Risk Budget
Now that you have shifted into Asymmetric Risk-Reward Opportunities (More Gain for Less Pain), it's time to put your Risk Budget to work.
After determining your risk budget, let's say you are comfortable risking $2 in the example above. What do you do?
You can meet your Risk Budget by investing:
Option 1: 100% exposure into the Win $3, Risk $2
Option 2: 200% exposure into the Win $2, Risk $1 (resulting in a Win $4, Risk $2)
Now what if your risk budget is only .50 cents? Most investors who fall in this category sit out in cash missing out on returns because they don't think an investment exists for their budget. But you can throttle exposure down as well to reach a risk budget.
Option 1: 25% exposure into the Win $3, Risk $2 (resulting in a Win $0.75, Risk $.5)
Option 2: 50% exposure into the Win $2, Risk $1 (resulting in a Win $1, Risk $.5)
In both cases, shifting into the best Risk-Adjusted Opportunity is the right choice to meet any Risk Budget.
Step 4: Repeat
Once you start measuring risk, you observe one common truth: Their is no static "average risk" for an investment.
Risk is dynamic and it changes over time. This is true for EVERY asset class (even private real estate).
On top of that it tends to be "streaky. Long periods of low risk punctuated by transient periods of risk explosions.
The key to this final step is to periodically confirm your risk budget (we recommend this annually), re-assess the best Risk-reward opportunities (our algorithms adjust this daily to monthly depending on the model), and finally adjust your exposure to ensure your portfolio never deviates from your risk plan. This results in much more predictable profits vs. losses over your career.
Conclusion
Risk Management has the ability to create new investment choices (with higher return or lower risk) that aren't inherently obvious or readily available to investors. Once an investor sees the light, it's hard to go back to abdicating risk management to "the market". If you want to learn more about how Damris Capital finds Asymmetric Risk-Reward Opportunities sign up here to get instant access to the historical performance of our models (as well as information about how they work).