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Tag Archives: risk management

Risk Management and Psychology

24 Friday Jan 2014

Posted by JC in Uncategorized

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risk management

Investing well requires you to be fairly numerate and to stay within your (hopefully expanding) circle of competence. Beyond that, risk management is key.

I often describe my manner of investing as a risk-management approach. My first duty to myself as an investor is not to blow up my portfolio when the market goes against me. I must live to fight another day. The usual risk management tools are all useful: diversification, asset allocation, seeking a margin of safety, behaving like a business owner (not a renter), seeking businesses with economic moats, keeping an eye on valuation, addressing the sleep-at-night factor during good times, and keeping a long-term orientation. These are all necessary, but not sufficient.

The biggest risk to manage is the risk of emotional self-sabotage. You can count on the fact that a big decline will make you want to sell to stop the pain. This fight-or-flight response was evolutionarily useful to avoid predators, but it is disastrous if obeyed in investing. This is why psychological self-knowledge and managing my emotions is a key part of my risk-management approach. Being aware of this tendency to self-sabotage and building an intellectual and emotional bulwark against it is some of the most important work that an investor can do. This is what Ben Graham was onto when he said, “The investor’s chief problem – and even his worst enemy – is likely to be himself.”

It is human nature to want to sell when the market is going down and buy when it is going up. Accept that, but build in the self-knowledge and safeguards to your process to keep yourself from snatching defeat from the jaws of victory.

All else being equal, unless some fundamental deterioration of the business has happened, you should like it more when it is cheaper than when it is expensive. If you are properly prepared, a selloff brings the possibility to profit from the irrationality of others.

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