Are you following the Rules of Risk Management?

Numerous questions are on our clients' minds right now - what do we do now that our investments are down? How should we invest our money in these times of uncertainty? Should we put it in cash and wait until things get better?

Getting it right

The one answer we can give is that we cannot predict the future. This basic fact of life seems to elude many people, including professionals such as investment advisors, managers, financial gurus, and investors. The financial pages of our newspapers are full of predictions; the reality is that most of these predictions turn out to be wrong. For example, all forty-three forecasts by major institutions for economic growth in Britain in 1999 turned out to be erroneous. Yet forecasters continue to predict since that is their job; however, otherwise rational people continue to take their prophecies seriously and act on them.

Never has risk management been as important for the individual investor as it is right now.

Dealing with risk

It is important to distinguish between taking risk and managing it. A key aspect of managing risk and a necessary first step is to recognize what risks you are taking, the potential consequences of each, and what you can do to mitigate those risks.

Managing risk does not mean placing all your funds into the relative safety of a bank account, GIC, or even a government bond. That strategy can be risky too, because the investor runs the danger of missing out on economic growth or simply being left behind by inflation.

As investors, we must accept that we live in an unstable and therefore uncertain world. Natural catastrophes and political upheavals are unpredictable, yet at the same time they are a virtual certainty. Our investments are affected by them and by a thousand and one other capricious certainties. We know that the price of oil will fluctuate, as will the major world currencies. We know that new technologies, some of them with revolutionary impacts, will appear. We know that companies will collapse and governments will fall. We know that terrorists will strike. These are all facts of the modern world. If we are to succeed as investors, we need to accept these facts before going into riskier investments.

Avoiding risk

We don't know when these events will occur. So what do we do? We think hard about the scenarios, and design a portfolio such that no single occurrence will have a disastrous impact on it. We make sure that we select a portfolio with more upside than downside. We diversify our holdings and try to rebalance on a regular basis to take advantage of swings in different markets.

Rational investors envision a wide range of possible futures. Once they have assessed all the potential outcomes, they can adjust their investment portfolio accordingly - not to make it risk free, but to make it better able to maintain its value. At first glance, this might seem like simple common sense - and it is. However, in practicality, it is hard to maintain that discipline over a number of years. Most investors pay too much attention to past performance and short-term fluctuations and do not spend nearly enough time on the actual discipline of portfolio management.

Steps for success

Good investors follow three main rules in risk managing their portfolios:

1) Know what you own

If you cannot explain your investment process and holdings to a five-year old, it is probably too complex. Each investment in your portfolio should follow a strict discipline for when to buy and when to sell it.

2) Use multiple scenarios in evaluating the risk

Risk is a funny thing. In our experience, when times are good and returns are abundant, some investors throw caution to the wind and have a very high tolerance for risk. But the slightest disruption will cause those same investors to abandon a perfectly good investment and run for the hills. What you should be doing before you invest is understanding the upper and lower limits of the investment choices and then asking yourself: "I know I can live with the upside, but can I live with the downside?" If the answer is no, invest elsewhere.

3) Anticipate regret

The one valuable piece of advice that every long-term investor will relate is that you are not always going to be right. There are times when you will regret your decisions. If you can accept this adage before you invest, it will help you to be more disciplined in your approach to portfolio management. Don't be scared off if an investment did not work out exactly as you thought it would - simply re-adjust your process so you don't make the same mistake twice, and move on.

Only when we realize that each investment is different and that the perception of upside and downside varies according to one's experience, age, and personality can we really understand it. Each of us has to take into account our individual situation, both financial and psychological, when we make investment decisions.

If you always consider these three rules, you will be managing risk logically and consistently.