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 shortterm
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 longterm
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 readjust
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.

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If you would like to take this opportunity to review your portfolio, please
contact
your closest CARP Certified Advisor.

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