We live in a very uncertain world. The unfolding of events in the Arab world was unforeseen. Moreover, the future course of events is difficult, if not impossible, to predict.
Add to this the uncertainty that surrounds our economy. Few would argue that the U.S. economy and the global economy are benefitting from an unprecedented level of fiscal and monetary stimulus. Given its vast scope, the effects of this stimulus will be far reaching and many of its consequences will only be known and understood in hindsight. Smart and reasonable people disagree on whether these policies – along with the serious economic problems they are meant to address – will lead to inflation or deflation. Add to that the reality that the duration and shape of these policies will largely be determined by future political outcomes and it’s no wonder investors sometime feel like they are playing three-dimensional chess.
Yet, this is the world we live in. As investors it is critical that we consider the downside first. You are the risk manager of your portfolio. Just as CEO’s of many of our leading financial institutions badly miscalculated by delegating this task to others, it would be a mistake to stick your head in the sand and not understand the risks you are taking with your precious capital.
Paying lip service to risk management is easy. Everyone does it just like every businessman is fond of saying that his people are his most precious asset. Words and deeds are two entirely different things. Buffett is fond of the book When Genius Failed because it shows that even very smart people can do very risky and dumb things with their capital.
Here are a few ideas that may help you with managing risk.
- Set aside a regular period of time to carefully go through your holdings and consider the risks involved in each position? Create a checklist to use in doing this assessment.
- Are you exposed to life changing economic risk, meaning can you envision a scenario that has any likelihood of happening where you could be wiped out?
- Are you exposed to ignorance risk in that you don’t understand a given position and why you are holding it? Consider that it appears likely that Buffett liquidated Lou Simpson’s stocks picks (Buffett’s motive is speculation on my part) when Simpson left Geico because Buffett does not back into positions and hold things that he does not understand (in the Buffett predictive sense of the word), even if they are otherwise good companies. Remember that you are much more likely to succumb to fear and dump a position in a downturn if you lack conviction born of your own work.
- Are you holding overvalued securities that subject you to permanent loss of capital in a downturn?
- Is your concentration in long-equities too high or are you overly concentrated in one stock or one industry?
- Have you considered how the businesses in which you are invested would do if high inflation ensues? How about if deflation and low-GDP growth develop?
- Do you have positions that are overly leveraged and overly dependent on the capital markets?
- If a company’s valuation is predicated on growth, how certain are you that the growth will materialize?
This list is not exhaustive, nor is it intended to be. The point is that you are your own risk manager and that is something that in my view should be taken very seriously. Develop your own process and then have the discipline to follow it. Many great investors are great because they managed the downside and let the upside take care of itself. You can’t win if you don’t finish. Moreover, serious permanent loss of capital disrupts compounding and makes it much more difficult psychologically to step up to the plate when future fat pitches appear.