Understanding Risk Management and How to Protect Your Resources
The following is adapted from Financial Freedom Blueprint by Louis Llanes.
In the world of finance, risk management separates the winners from the losers. It’s more important than how well you select stocks or predict the markets. If you get it right, then you can pursue higher returns while you manage your downside.
Risk management requires you to have rules to size your investments and, most importantly, to exit when risks are too high. There are times when you will be tempted to break your rules. This is a big no-no and usually leads to disappointment. The lack of solid risk-management guidelines is the number one reason for poor performance; therefore, I believe it is crucial to understand your personal risk profile and to institute rigorous guidelines.
What Is Risk?
How much volatility are you willing to assume to pursue returns? The answer to this question is your risk tolerance. In the context of investing, risk is the chance that you could lose money. Each investment has uncertainty no matter how much research you have done. It doesn’t depend on how smart you are. You can never know every aspect of your investment or perfectly predict the future. For these reasons, I believe capital should be managed to limit losses as much as possible while leaving the upside open. Limiting losses requires you to predefine your risk tolerance and convert it into measurable statistics.
Does Buy and Hold Make Sense?
Some investors believe that stocks go up over the long haul, so why not just buy and hold them and not worry about it? Although it is true that stocks in the United States have historically trended upward, there are very long periods of poor performance. This happened in the 1930s, 1970s, and the first decade of this century. Longtime periods of poor stock performance also happen in other countries.
In Japan, the Nikkei 225 stock index peaked on December 29, 1989, and as of February 24, 2021, it has yet to recover. That’s thirty-two years of no growth. You must have an extremely long time horizon to weather that type of storm. If you were a buy-and-hold investor, surely you were disappointed, and hopefully you were not retiring during that time. This is one reason why I recommend an investment plan that diversifies the source of returns and does not rely on the performance of a particular market.
It’s also a big reason why I recommend investing in flexible strategies that have opportunities to profit in both up and down markets.
Finding Your Comfort Zone
Since we know that fear and panic can infect our decision-making at the wrong time, it’s best to set up a comfort zone that defines your risk tolerance. Staying in your comfort zone will help you avoid a permanent capital loss. You don’t want to be stuck in cash at the wrong time and then reinvest late. By the time you are comfortable enough to get back in again, chances are you already missed out on good profits. The combination of locking in a loss and making less on the way up will hurt your results. It is difficult to “get back on the horse” after you feel burned. It’s just human nature.
Making Up a Loss
Making up a loss is not the same as generating a gain; it’s much harder to claw back from a severe loss simply because of the math. You have to earn a higher return to break even, especially the larger the loss becomes. For example, if your portfolio goes down 50 percent, you need to go up 100 percent just to break even! In this case you need to double the return of your prior loss. How many times do investments double in value, and how long will that take? Valuable time is wasted when trying to recover from an excessive loss.
Excessive market volatility truly affects our emotions. The psychological cost is brutal when we are outside our comfort zone. We can’t sleep at night and we become nervous. The mental and physical pain keeps mounting to the point that our well-being is shot. The bottom line: excessive risk is really not worth potential gains.
For more advice on how you can protect your portfolio, you can find Financial Freedom Blueprint on Amazon.
Louis B. Llanes is the founder of Wealthnet Investments, LLC, a fiduciary registered investment advisory firm. Prior to founding Wealthnet, Louis held several investment management positions, including senior portfolio manager for the US Bank Private Client Reserve, quantitative trader for a private fund, and investment consultant for Kemper Securities. Louis holds the Chartered Financial Analyst (CFA) and Chartered Market Technician (CMT) designations, an MBA from the University of Denver, and a BS in Finance from the University of Colorado. A contributing author of The Handbook of Risk, he wrote Financial Freedom Blueprint to help busy professionals enjoy the retirement they deserve as early as possible.
