In the last article, we have talked about the identifying risk and recognizing risk. Now, in the current article, we discuss regarding controlling the risk. Generally, in the market, we put much emphasis on the higher absolute return instead of superior risk-adjusted return. But the great investors are those who focus on the risk and generate moderate returns with low risk or high return with moderate risk.
Generating higher returns with the higher risk for a long time is rare in the market. The risk of losing money arises when our investment meets adverse situations and Loss does not occur till the negative events occur. We should always focus on controlling the risk because we do not know that when the negative situation arises and we met losses.
When we bought the home, we check that the home is constructed in a way which can be protected by earthquake or not. The similarly, we should focus on our investment. We should focus on the situations where the occurrence of such negative situations can destroy our wealth. And work as an earthquake in our financial position.
It can be possible that an earthquake will never happen in life long, but we bought the home which can be protected with an earthquake. Similarly, it may be possible that adverse situations will not arise during our investment time, but we should focus on raising of adverse situations and how we can able to protect our wealth from such situations.
The risk is not always easily visible. If our surrounding environment is positive, then we start thinking that negative situation may not arise due to the influence of that positive environment. But in fact, the risk is always present in the good environment also. And anytime good environment can easily turn out to the bad environment. Such transformation does not come to us with the prior intimation. We must have to be ready properly with such considerations before making investment decisions. Even controlling risk is becoming essential into the good environment because nobody is talking about risk and in a bad environment, risk takes care of itself because everyone fearing of risk.
Generating superior return compared to benchmark with the similar risk nature is a good performance. But, a good value addition is while we generate a return which is like the benchmark return with the lowest risk and with proper controlling of the risk. Such scenario is even better.
When the environment is positive, everyone rides the wave and we cannot able to say which one is better. (Good article – Doubled your Money in Last 3 Years ? Skill or Luck ?)
So that we should always focus on the controlling risk, whether it will rise or not. Because we cannot able to really predict the occurrence of the risk.
Careful investors always know that they cannot able to know the future so that they try to focus on controlling risk and try to factor the risk of loss of capital while they make any investment decisions.
We start avoiding focusing on risk as the environment is going positive. Initially, we might put weight on risk, but many times that risk might not get triggered. So that we start avoiding it and started believing that there is a no risk into the environment. Such risk will not occur and we saved from the negative situation.
As we have seen in Russian Roulette with 100 chances, we may save for 99 times, but the 1 time can kill us. Or if we are lucky we can be saved all the 100 times. It doesn’t mean that there is no risk or risk may not arise in the future.
We constructed belief in our mind from our past experiences. If we have seen the positive environment, then we have made belief that negative situations never come. We should always keep in mind that occasionally extreme situations can arise and that can be out of our all belief.
In the year 2007, also welcome structured products, huge capital inflows, etc.
We should not run from the risk but should manage risk intelligently. We should take the risk, but at the appropriate time and most importantly at an appropriate price.
When we walk on a road with keeping our eyes closed and we do not meet an accident, then it’s not our talent, it’s a pure luck which plays out. We are a real blind if we consider such situation as our own skill. And such risky situations do not stay rewarding for a long period and we must walk on the road with keeping our eyes open.
Read for more detail: The Most Important Thing Illuminated by Howard Marks