The sixth idea to improve your investment process is to improve your risk management. The recent financial crisis was another reminder that smart people are capable of doing very foolish things with their money. We all need to re-double our efforts to improve how we manage risk. You are the chief risk officer of your portfolio, and you should never completely delegate that to someone else.
In the book The Warren Buffetts Next Door, investor Bob Krebs tells a story about risk management. Krebs was impacted by an article about fifty career carpenters. It told how ten of the fifty went thirty years with their fingers intact even though they worked daily with saws and cutting tools.
The forty who lost a finger said they knew just before an accident that they were at high risk, but failed to yield to a primal scream inside that was yelling STOP. The other ten, in contrast, always listened to this inner voice. They never operated equipment when tired, rushed or after drinking.
One old-timer, who had gone 70 years without an accident, would carefully inspect his hands for three or four minutes before working. He’d take careful stock of his fingers and imagine how awful it would be to lose them.
I have adapted this simple approach and resolved to regularly review my investments with the use of a risk checklist. I look for flaws in my thinking and risks I’m taking that aren’t worth it.
Here are some of the questions I consider regarding each investment:
(1) What is the competitive risk the business is facing?
(2) Does the investment expose me to life-changing economic risk?
(3) What is my ignorance risk? In other words, am I holding an investment I don’t understand?
(4) Is the stock materially overvalued exposing me to overvaluation risk?
(5) Am I exposed to macro risk? For example, am I continuing to hold a large percentage of my portfolio in equities when the market is clearly overvalued?
(6) What about leverage risk? Is the business overleveraged and vulnerable to a shock if it can’t access the capital markets to roll over its debt?
(7) What other risk to the business am I ignoring because it doesn’t fit in neatly with my thesis? Remember, your brain works hard to ignore information that runs counter to a deeply held belief.
Simply thinking through a series of questions like these will help you avoid costly mistakes and permanent loss of capital, provided like the carpenters who kept their fingers intact, you heed the warning of your inner voice.