investment.
You may be surprised just how much risk is manageable.
With proper portfolio design and investment strategy, you can usually manage away every significant risk (except one or two) to acceptable proportions.
These one or two remaining risks define the specific, uncontrolled risk profile for that investment. It’s the leftover risk you must live with.
In order to manage away the risks of loss, you must first know what risks are inherent to the investment you’re considering.
Using the stock market as an example, there are almost a limitless number of risks, but for practical purposes, they can be profiled down to a few major categories:
1 “Company specific” risks include things like accounting scandals, lawsuits, and mismanagement – anything unique to the company that’s not part of the industry. These risks are managed away by diversifying among multiple companies. Mutual funds and exchange traded funds (ETF) are great examples of simple, cost effective tools to diversify away company specific risk.
2 “Industry specific” risks include a downturn in demand for widgets, changes in consumer tastes, disruptive technology changes, and industry law changes. This risk is controlled by not concentrating your portfolio in a single industry.
3 A closely related risk is “investment style” risk such as value vs. growth, or large cap vs. micro cap. The market will vary how it rewards or punishes different investment styles over time. For this reason, you should manage this risk by not concentrating too heavily in any one specific investment style like micro cap, value, or growth.
4 “Market” risk is associated with a general downturn in investor’s appetite for stocks, causing an overall reduction in the valuation level of equities. This risk is manageable through a sell discipline, hedging, or by diversifying into non-correlated markets such as real estate, commodities, cash, or international equities rather than solely domestic equities.
Again, the above risk profiles are designed to illustrate stock investing. However, the same principles can (and should be) applied to every asset class in your portfolio.
“All of life is the exercise of risk.”
— William Sloane Coffin, Jr.
For example, if you invest in real estate, you wouldn’t want to over-concentrate in one property, or one city, or one type of property. It’s wiser to diversify away those risks that can be managed, rather than concentrate them.
The Second Step in Risk Management is to Create a Controlled Risk Profile
Once the risk profile for an investment is fully understood, your job as risk manager is two-fold:
First, you must design ways to manage away whatever risks can be eliminated.
Second, you must accept only investments where the remaining uncontrolled risk profile doesn’t overlap with other investments in your portfolio.
The end result is a minimization of the total risk for the entire portfolio, because it’s composed of mostly uncorrelated, managed-risk investments.
Why bother with all this? Because lower risk means losing less money when you’re wrong. That’s important because losing less when you’re wrong results in making more when you’re right.
“Often the difference between a successful person and a failure is not one has better abilities or ideas, but the courage that one has to bet on one’s ideas, to take a calculated risk – and to act.”
— Andre Malraux
Your ability to manage risk is limited only by your knowledge and creativity.
The critical point to understand is that each investment has unique risk management tools available that are directly related to the unique characteristics of the investment and the market it trades in.
For example, one of the largest risks to income-producing real estate is a change in interest rates, since mortgage interest is one of your biggest expenses. This risk can be managed by locking down long-term, fixed-rate, fully-amortizing financing.
You can also limit your loss in real estate to the amount of your down payment through the use of non-recourse financing, thus controlling the risk of widespread capital losses impacting your entire portfolio should one property turn into a loser.
Notice that these two financing tools for managing risk are unique to real estate and aren’t available to investors in business or paper assets (the other two primary paths to wealth).
Each market has its own unique characteristics for managing risk, and the paper asset markets are no different.
For example, most securities markets offer high liquidity and low transaction costs, making them a natural candidate for cost effectively managing many risks through a sell discipline.
In fact, many mutual funds have zero transaction costs and daily liquidity through their commission free exchange privilege.
However, using a sell strategy in real estate to control downside capital risk doesn’t make sense compared to paper assets because of the prohibitively high transactions costs, and possible low liquidity during tough market conditions when you would want to sell.
In short, each market has unique characteristics that can be exploited to effectively manage the risk inherent in that market. What works in one market to lower risk may not apply in another market.
In summary, your first due diligence question is to uncover all the ways you can lose money with an investment.
The first step in this process is to profile what the risks are inherent in that investment.
The second step is to develop strategies to control losses that match the unique character of that asset should the worst come to pass.
This is the essence of active risk management.
“And the day came when the risk to remain tight in the bud was more painful than the risk it took to blossom.”
— Anais Nin
After you have managed away all risks that can be eliminated, you’re left with a specific, uncontrolled risk profile for that investment. This leads to your final risk management step, which is to make sure the remaining risk profile doesn’t correlate with other investments in your portfolio.
For example, when I purchase apartment buildings, they are financed with long-term, non-recourse debt to control both interest rate risk and to minimize total risk of loss should Murphy’s Law prevail.
In addition, each building is located in a different geographic market to assure the uncontrollable risk profile associated with location doesn’t correlate to other assets in my portfolio.
The risk of loss on each apartment building similarly has no correlation to the risk inherent in my paper asset portfolio or my business. Each risk profile is unique to the asset.
This excessive focus on risk might seem pessimistic to many, but my experience is quite the opposite. All it really does is bring balance because investing is by definition a game of greed.
The objective is to make money so the game is naturally played offensively by looking for the profit. By disciplining yourself to look for the loss, you’ll balance offense with an equally strong defense to create a winning team.
Stated another way, the hallmark of great investors isn’t just strong positive returns, but consistent returns through all market conditions.
This can only be achieved by focusing on controlling losses through disciplined risk management.
Due Diligence Question #2: How Will This Investment Help Me Achieve My Personal and Portfolio Objectives?
The portfolio objective for most investors is to maximize profit with minimum risk.
You achieve this goal by building a diversified portfolio of non-correlated, risk managed,