How do we manage risk in our lives?
The first step is to acknowledge that risk is omnipresent and it’s not our friend. Oblivious investors are their own worst enemies. The Financial Crisis came about in part because real-estate and bond investors thought the world had fundamentally changed to have a lower risk profile. They became complacent and bought complex debt instruments in larger amounts than ever before. They borrowed money to purchase these investments, hoping to enhance returns. But the borrowings multiplied their losses – and even wiped them out – if they had to sell when the market was down. Leverage works both ways.
The world will always be risky. It’s not easy to observe the various forms of risk, and risk can’t be captured in a single measurement. Risk is uncertainty about how the future will play out, and the chance of taking losses if – and when – bad things happen. Since risk is about experiencing loss, higher asset prices lead to greater investment risk. One of the best ways to manage risk is to limit the price we’re willing to pay. In the run-up to the Financial Crisis, investors paid too much for bonds backed by crummy credit. This made our entire financial infrastructure riskier.
Worry, distrust, skepticism, and reticence are essential elements to proper risk management. That’s 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.
Risk management matrix. Illustration: Nirjal stha. Source: Wikimedia
Although risk exists only in the future, managing risk doesn’t require us to make predictions. We just need to recognize what’s happening in the present and formulate a plan. The more anxiety we see, the less risky the market is. This is the “paradox of risk”: overconfidence leads to danger, and healthy skepticism creates safer portfolios.
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”