Risk Management

Risk refers to the likelihood that your assets will decrease in value.

Risk is unique in that it applies to the probability of losses occurring, and the potential value of those losses.

In finance, risk is considered a type of cost.

All decisions you make have some degree of inherent risk.

Inaction too often has the greatest amount of risk, so rather than becoming paralysed by attempting to avoid all risk, look at it as a type of cost that allows you to calculate whether a financial decision will reap greater benefits that the potential losses and to compare the available options.

There are a variety of different ways to:

• avoid risk,
• reduce risk, or 
• even share risk.

Each of the above has a price.

By calculating the cost-value of specific risks, it becomes possible to determine whether any of the tools available for managing risk are financially viable and are themselves an appropriate risk.

Risk management is a critical part of financial success.

You should explore:

• the different types of financial risk, 
• the ways in which risk is measured and 
• how to effectively manage the amount of risk to which you are exposed.

Additional notes

Ways to avoid risk:  diversification and appropriate use of derivatives

Ways to share risk:  insurance

In the end, the best tool you have available to you in limiting the costs associated with risk is simple due diligence.

• Do your research, make decisions which make sense to you and keep watching so you know when that decision doesn't make sense anymore.
• If someone's credibility is in question, risk mitigation can come in forms as simple as asking for a nonrefundable down-payment, just as banks will sometimes ask for collateral before issuing loans.
• Preparing for losses can be as simple as keeping enough funds available in a liquid form so you can pay your bills until you regain your losses.  
• The duration of your exposure to losses can be shortened by ensuring you always have an exit strategy - before you commit to a decision, develop a way to undo it in a worst-case scenario.

Like most things, you get out of risk management that you put into it, and as the amount of potential risk increases, so should your intolerance for sloppy risk management.

Barry Ritholtz

Columnist

On Investing: The many hats of great investors

The crowd becomes an unthinking mob at tops and bottoms. Being able to read the emotional state of the market, as well as keeping your own emotions in check, are hallmarks of great investors.

Trial lawyer: Good litigators are always skeptical, but not negative. Is that witness telling the truth? What is motivating him? Is the opposing counsel’s argument logical? Being able to answer these questions makes for a good lawyer – and a good investor.

All CEOs want you to buy their company’s stock; every analyst wants you to follow his equity calls; every fund manager wants to run your money. When it comes to investing, everyone is trying to separate you from your money. Good investing requires good judgment. Being able to recognize valuable intel versus the usual blather is a huge advantage.

Like a good litigator, you must question data, consider alternative explanations, argue against the obvious. You cannot blindly accept everything you hear as truth, nor can you reject everything out of hand. Being able to discern between information that is valuable and that which is not, is crucial.

Mathematician/statistician: Investing is filled with math: compound interest-rates, dividend yields, long-term gains, price-to-earnings ratio, risk-adjusted returns, percentage draw downs, annualized rate of returns.

Don’t worry if you suffer from math anxiety: If you can operate the simplest calculator — even the free one that came with your computer — you have the requisite math skills needed.

If you follow the professional literature there is a plethora of advanced mathematical formulas of dubious utility. Value-at-risk is a complex mathematical formula that was supposed to tell Wall Street banks how much risk they could safely assume. It failed to prevent them from blowing themselves up during the credit crisis. The Sharpe ratio measures the excess return — the “risk premium” — an investment strategy has. Even William Sharpe, its creator, has said it’s been misapplied by Wall Street’s wizards.

Investors can ignore these sorts of mathematical esoterics. But understanding basic math is key.

Accountant: When you buy a stock, you are buying an interest in a company’s future revenue and profit. How much you pay for that future cash flow determines whether you are over or under paying. That means understanding the basics of a company’s books is a key to recognizing value.

An understanding of basic accounting is essential to grasping the fundamental health of a company or business model. It is how you determine whether an existing company is profitable, or when a young firm might become profitable. But it also can help you determine when a formerly profitable company is heading down the wrong path.

You don’t have to be a forensic accountant. These are sleuths in green visors poring over pages and pages of quarterly filings and footnotes, looking for evidence of fraud or accounting shenanigans. Forensic accountants are the guys who discovered the frauds at Enron and Worldcom, and they warned about AIG and Lehman Brothers.

Amazingly, even after these frauds were revealed, many investors refused to believe them. Having a basic knowledge about accounting can help you understand and heed the work of forensic accountants.

You don’t need to have an MBA or doctorate in economics to be a good investor. Indeed, as the spectacular blow up at Long-Term Capital Management has taught us, these can be impediments to good investing.

Instead, you need to develop more general skills. Learn market history, understand crowd psychology, how to think critically, be able to do simple math and understand basic accounting. Do this, and you are on the path to becoming a much better investor.

Ritholtz is chief executive of FusionIQ, a quantitative research firm. He runs a finance blog, The Big Picture.

Learn Patience. Yes, patience is a virtue you must have as a value investor.

You can never count on stocks for short-term needs.  As long as you have at least 5 to 10 years and you have chosen a solid company, there's a good chance you won't have to take a loss on a stock.  But you must be patient and willing to wait for the market to turn around for that stock.

Yes, patience is a virtue you must have as a value investor.  To get a good bargain, you need the patience to wait for a stock to recover, as well as the risk tolerance that allows you to hang tough even if the stock has been beaten down.

How do you know if the company is still on the right track?  That comes with research and what Graham calls intelligent investing.

To be an intelligent investor, you must have the time and knowledge to carefully pick your stocks and then monitor your portfolio.  So if your time constraints won't allow you the time you'll need for the research, you may need to be a passive rather than active investor.  These differences will impact the type of portfolio you want to build as a defensive value investor.

You also need to know how you will react when the market takes a nosedive and drops 10% to 15%.  Are you the type of investor who will run for the hills and sell off all your stock?  If so, you do not have the risk tolerance to be an active investor; you need to develop a more passive portfolio with steady returns.  A down market is the time an active defensive investor looks for good buys.

Another question you must ask is, what will you do when the market is going up 10% to 15% or more?  If you think you're the type of investor that will jump on the bandwagon, you don't have the discipline to win as a value investor.  When the market goes up that dramatically, stocks are usually overpriced.  Active defensive investors might sell SOME winning holdings, but they would NOT likely buy any stock during this type of market unless they believe they've found a good beaten-down stock that the crowd missed.

While value investors need to learn patience, you should never hang tough if you believe you made a mistake and the company is performing much worse than you expected, or if you no longer believe in the company's management team.  Take your hit and get out before things get even worse.

Investment Performance Depends on Intelligent Effort

Graham disagreed with the usual postulated risk-return relationship, that is, to earn a higher return an investor must accept higher risk. To the contrary, he felt that the more intelligent effort one put into investing, the better the bargains bought. And the better the bargains, the lower the risk.

Thus intelligent investing provides high yields and low risk. Finance academicians often fail to appreciate this point.

Inactivity is also an intelligent investing behaviour

Warren Buffet wrote to the shareholders of Berkshire Hathaway:

Inactivity strikes us as intelligent behaviour. Neither we nor most business managers would dream of feverishly trading highly-profitable subsidiaries because a small move in the Federal Reserve's discount rate was predicted or because some Wall Street pundit had reversed his views on the market. Why, then, should we behave differently with our minority positions in wonderful businesses? The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries. In each case you simply want to acquire, at a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor whether these qualities are being preserved.

When carried out capably, an investment strategy of that type will often result in its practitioner owning a few securities that will come to represent a very large portion of his portfolio. The investor would get a similar result if he followed a policy of purchasing an interest in, say, 20% of the future earnings of a number of outstanding college basketball stars. A handful of these would go on to achieve NBA stardom, and the investor's take from them would soon dominate his royalty stream. To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team.

In studying the investments we have made in both subsidiary companies and common stocks, you will see that we favour businesses and industries unlikely to experience major change. The reason for that is simple: Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek.

I should emphasize that, as citizens, Charlie and I welcome change: Fresh ideas, new products, innovative processes and the like cause our country's standard of living to rise, and that's clearly good. As investors, however, our reaction to a fermenting indsutry is much like our attitude toward space exploration: We applaud the endeavour but prefer to skip the ride.