Three ways of mitigating investment risks
When we make any investment decision, there always will be a risk against which we make return. Mark Zuckerberg famously quoted about risk as ‘the biggest risk in life is not taking any risk’
When we make any investment decision, there always will be a risk against which we make return. Mark Zuckerberg famously quoted about risk as 'the biggest risk in life is not taking any risk'. And that risk is a probabilistic event and mostly not certain.
If its certain then the potential returns from such an investment comes down as the risks would easily be discounted for. That's the logic behind the perception that higher risks could derive higher returns from an investment. Also, certain times, the risk can't be assessed i.e., one can't expect the source or the possibility of the type of event.
Howard Marks has brilliantly described risk with this story: "I tell my father's story of the gambler who lost regularly. One day he hears about a race with only one horse in it, so he bet the rent money. Halfway around the track, the horse jumped over the fence and ran away." Now how would anyone imagine such an outcome and that unimaginable is what risk looks like.
So, one can't plan for all risks or no model in the world can avoid risk but could mitigate to an extent, only. Carl Richard says it best, "risk is what's left over when you think you've thought of everything else".
So, most of the grave risk originates from that is unknown or unthought of as if no one has thought about it, then none is prepared to handle it.
History is littered with such examples both in finance and otherwise. Though, risk could be quantified and assessed in an investment or a portfolio, psychological effect on us is deeply varied. If we were to define a risk through a percentage of possible loss to the investment, then the emotion attached or experienced due to such a loss is not equal to that of the emotion generated to the same quantum or percentage of gain experienced or achieved.
Loss aversion, pioneered by Daniel Kahneman suggests that when choosing among alternatives, people avoid losses and optimize for sure wins because the pain of losing is greater than the satisfaction of an equivalent gain. Innumerable studies have shown that the desire to avoid losses is wired more strongly into our brains than the desire to achieve gains as future outcomes are mostly uncertain. Quoting Marks again, 'there's a big difference between probability and outcome. Probable things fail to happen - and improbable things happen - all the time.'
So, where does luck come into the picture? Does luck play any part? How many of us would like to be associated with 'dumb' luck? One doesn't need to be smart to be lucky, so we add up various variables that would eventually lead us to gain some clarity on risk.
Luck and risk are two sides of the same coin, but we treat them differently. This is because we tend to appropriate reasons of our conviction or actions for some random event that helped us to make the rewards but any loss due to risk is associated with that event.
In other words, returns are always adjusted for risk but never for luck. Does this mean that all hard work is lost? Nope! The biggest risk mitigation is about how one behaves towards the market reactions than how markets respond to the news. What has trumped investing is consistency, persistency and diligence.
The consistently in behaviour during various cycles of markets (systematic investment), the persistence in sticking to the plan (asset diversification), and the diligence to stay invested through the cycles to gain of the investment (compounding).
These three principles could help mitigate the risk effectively for an individual. Arriving at a plan in tandem with the risk appetite and timelines. Contributing to the plan over the period of the desired period with possible alteration to the allocations when desired allowing the investments do their bit. Would like to end with a quote from one of the greatest value investors of all time, Charlie Munger, 'it's not supposed to be easy. Anyone who finds it easy is stupid.' The efforts are needed but at right places.
(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at firstname.lastname@example.org)