Of Risk and Return (Part 2)

How do we manage risk?

Photo: Dodgerton Skillhause. Source: Morguefile

The first step is to acknowledge that it’s there, and it’s not our friend. Unworried investors are their own worst enemies. The Financial Crisis came about mainly because investors thought they were living in a low-risk world. They purchased novel and complex instruments in greater amounts than ever before. They borrowed money to buy them, which multiplied losses when they had to sell. Leverage works both ways.

The world is always risky. It’s not easy to see, and it can’t be captured in a single number. Risk is uncertainty about how the future will play out, and the chance of taking losses when bad things happen. Since risk is about losses, higher prices lead to higher risk. One of the best ways to manage risk is to limit the prices we are willing to pay. In the run-up to the Financial Crisis, investors were willing to pay too much for bonds backed by lousy loans. This make the whole market more risky.

Worry, distrust, skepticism, and reticence are essential elements to proper risk management. This is why Sir John Templeton said that bull markets are born on pessimism and die on euphoria. Euphoric investors drive up prices and drive up the riskiness of the market.

Although risk exists only in the future, managing risk doesn’t require us to make predictions. We just have to recognize what’s happening now. The more fear we see in the market, the less risky it is. This is the “paradox of risk”: overconfidence leads to danger, but healthy skepticism creates safer portfolios.

Douglas R. Tengdin, CFA

Chief Investment Officer

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