Learn About the Markets

Learning to Love Risk

When the market was booming, we asked for readers to send in their stories about investing, both in the "I Struck It Rich" and the "I Got Creamed" categories. More than 600 readers responded. The remarkable thing about the stories was the common theme running through them all. Put simply: investors were embracing risk in ways few investors had in the past. The trouble with risk, of course, is that it is a double-edged sword.  It can bring both rich rewards and big losses. 

There may have been a bias in our story requests, in that we asked only for the extremes of the investing world. After all, to gain extreme reward, you must take extreme risk.

If we had asked for stories in the category of "I Underperformed the S&P by 1%" we might have received some stories from mutual fund investors.

Nevertheless, in reviewing the hundreds of stories that were sent in, there are some signs that what works in today's market is very different from what used to work.

The Old Principles

The old world was fairly clear on "what works."

Risk appropriateness and diversified portfolios. Buy and Hold. Love compound interest.

It used to be that all investors were encouraged to build a portfolio according to their risk level. Financial advisors, and brokers, were (are) trained to both determine an individual's risk level, and then build an appropriate portfolio to meet that risk.

Of course, not all trained professionals did that, or did it well, but that was (still is) the idea behind professional advice.

The problem is that this approach doesn't get the respect it deserves anymore. The "lure" of the market has been the repeated success stories of people making 10 times their money in one year. How can diversification and risk reduction compete against that?

Diversification, in general, is a good thing. It was preached universally, as mass media, starting in the late 1970's, and was a key component of the mutual fund era.

A diversified portfolio does reduce risk. But it also reduces reward. Many of the "I Got Creamed" stories that we received involved cases where an individual put "all the eggs" in one basket.

But if you don't consider the possibilities of risk, what value is considering diversification? It seems like many investors fall into this category.

The New Principles

The new world has a very different set of principles.

Heavily concentrated bets on a few stocks. Short-term turnover. Love that margin.

Back when we asked this question, investors were clearly trying to make very large bets on very few investments, in order to reap the big rewards. In addition, margin played a heavy role.

In addition, short-term positions are viewed as favorable. It's almost the complete opposite of the basic principles of the "old world."

Margin

Nearly all of the believable "I Struck It Rich" stories continually involved full use of margin. Margin is simply the way that you increase your winnings, when you do win.

But margin increases your risk, always. The problem is that to get one of the "I Struck It Rich" stories, most investors embrace margin.

There is nothing wrong with this approach, of course, if you are comfortable with the risk that is involved.

Unfortunately, many investors didn't take the risk side of the risk/reward ratio into consideration.

Self Deception

Success reinforces the idea that what you are doing is correct.

This is perhaps the biggest problem with a booming marketplace. The great success stories, both folklore and media stories, are all based on very risky, undiversified portfolios.

But risk appropriateness is being ignored. There are probably many, many investors with very risky positions, who have made money and therefore think they are doing everything correctly.

But when the risk side of the market bites, it hurts. Sometimes deeply.

That's what many of the "I Got Creamed" stories taught us. Investors who tried to "strike it rich" using the concentrated, undiversified approach, but then fell into the red, found it hard to deal with the loss. You may think their investment choices were dumb but the real problem is that most didn't make choices appropriate to their risk tolerance.

And it is likely that many of the "I Struck It Rich" investors also haven't made choices appropriate to their risk tolerance. They just didn't have that risk tolerance tested. Yet.

Determine Your Risk Level

What this boils down to is this: you must make a determination of your own risk level. Even if you are way ahead.

In fact, especially if you are way ahead, spend some time considering what would happen if your positions were cut in half overnight.

And then started to drift lower every day.

Until you've done that, and really considered how you would react, you haven't truly learned to love risk.

Robert V. Green