So how do you control your investment risk?
When you don’t know the future, how do you structure your investments? After all, investing is a bet on the future. The essence of risk management is the admission that we don’t know what the future holds.
The first tool is diversification. By placing small sums in different types of assets in different industries with different payout structures you minimize the chances that a single mishap will overtake your entire nest-egg. Some might cite the financial crisis of 2008 as a counter-example where a 100-year flood seemed to overwhelm every investment. But it didn’t overtake Treasuries—their prices rose.
Diversification is admission of our ignorance about the future. What else can we do? Another approach is to guess. I don’t mean “get a hunch, bet a bunch” sort of guess. I mean construct some reasonable scenarios about the future—guesses—and devote part of your portfolio to each one. That is, diversify, but not like a shotgun blast is diversified. Focus your investments on different scenarios.
Two years ago I looked at the government’s stimulus and guessed that it would lead to inflation. I was wrong about that. But my investments profited because they were linked to government bonds, which have performed well.
Risk means you might be wrong. Management means limiting your downside. Sometimes risk management actually makes money.
Douglas R. Tengdin, CFA
Chief Investment Officer
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