Risk Management: The Key to Long-term Financial Success
- Tuesday, November 01, 2005
If the mantra in real estate is location, location, location, then the mantra in investing is diversification, diversification, diversification. Diversification does not eliminate risk or assure against market loss, but it can lower your risk, which over the long run may bode well for you. As we said in the beginning, proper risk management begins and ends with diversification.
With apologies to David Letterman, here is my top 10 list of principles for investing:
1. Realize that financial shocks, like high oil prices, are an integral part of the investing landscape.
2. Realize that there are many more financial shocks ahead - we just do not know where or when they are going to hit.
3. Realize that jumping out of the market during a crisis is the surest way to lock in losses
4. Realize that to time the market successfully you need to know something the market has not already priced - and most of us do not have that unique information.
5. Realize that even the best constructed portfolio cannot fully protect from financial shocks - but it can certainly mitigate their impact.
6. Realize that broad diversification across stocks, industries, styles, countries, asset classes and managers is the best way to control risk.
7. Realize that investing - particularly equity investing - is a long-term proposition.
8. Realize that investing requires discipline
a. Not making emotional and reactionary decisions
b. Having reasonable expectations for risk and return
9. Realize that discipline requires an understanding of an investors risk tolerance.
10. Realize that an investor in an overly aggressive strategy is the quickest way to destroy discipline.
One concept I share with our clients is the "Law of Large Losses." (I need to copyright that term). Whenever you lose money in an investment, you always have to make a greater percentage just to get even. For example, if I lose 10%, I have to earn 11% just to get back to even. If I lose 20%, I have to earn 25%. If I lose 50%, I have to earn 100% (essentially double my money) just to get back to even. I believe mitigating losses is much more important than trying to "hit it big." When does 100% - 50% = 0%? Only in investing. If I earn 100% on my money, but turn around and lose 50%, I end up where I started. If I have $100,000 and earn 100%, it doubles to $200,000. If I continue to invest and lose 50%, I’m back where I started ($100,000). By the way, it doesn’t matter if I lose the 50% first or second. If I have $100,000 and I lose 50%, I’m left with $50,000. If that $50,000 earns 100%, I’m back to $100,000. Math is funny like that.
The goal in investing should be to minimize risk without giving up all of your upside potential. There is no panacea for risk - risk must be accepted if one is to generate return. Good portfolio construction is designed to eliminate as much unrewarded risk as possible - and that is best done through prudent diversification of your assets.
Steve Scalici is a Certified Financial PlannerTM with Treasure Coast Financial. He is co-host of God’s Money, which can be heard on the internet at www.oneplace.com. You can contact Steve at email@example.com.
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