The importance of risk management

Investing successfully requires patience and discipline more than anything else, especially late in a market cycle, as we appear to be in now.

The temptation to buy near the peaks is overwhelming and is the downfall of many well-intentioned investors, when, in fact, selling may be the wiser decision. How can one buy low if they don’t first sell high? I have learned over my six cycles as a money manager that my job involves not just the management of portfolios but the management of risk. We must avoid the depletion of capital due to market corrections by rebalancing portfolios toward fixed income (bonds) when stock valuations get stretched to the upside, as they are now.

With this in mind, I will highlight six time-tested risk management rules implemented by some of the most successful money managers of our time:

1. Warren Buffett, Berkshire Hathaway – “Be greedy when others are fearful and fearful when others are greedy.”

2. Ray Dalio, Bridgewater Associates – “The biggest mistake investors make is to believe that what happened in the recent past is likely to persist. Typically, high past returns simply imply that an asset has become more expensive and is a poorer, not better, investment. Ultimately, what goes up must, and will, come down. Eventually, great companies will trade at an attractive price. Until then, wait.”

3. Seth Klarman, Baupost – “Investor behaviour is the biggest risk in investing. Greed and fear dominate the cycle, which ultimately leads to buying high and selling low.”

4. Jeremy Grantham, GMO – “You don’t get rewarded for taking risks, you get rewarded for buying cheap assets. Successful investors avoid risk at all cost, even if it means underperforming in the short term. The reason is that while Wall Street and the media have you focused on chasing market returns in the shortterm, ultimately, the excess risk built into your portfolio will lead to poor returns in the long-term.”

5. Howard Marks, Oaktree Capital management – “Rule No. 1: Most things will prove to be cyclical. Rule No. 2: Some of the greatest opportunities for gain and loss come when other people forget rule No.1. Understanding that all things are cyclical suggests that, after long price increases, investments become more prone to declines than further advances.”

6. Jason Zweig, Wall Street Journal – “Regression to the mean is the most powerful law in financial physics. Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.”

7. Bob Farrell, Farrell Capital – “Excesses in one direction will lead to an opposite excess in the other direction”.

Today, the investment greed level is elevated, as determined by the fact that the amount of borrowed money in the U.S. stock market is at all-time high. That is referred to as a “risk-on” market. Of course, leverage works both ways and can be the fuel which ignites a selloff. I believe that adhering to the rules and guidelines of risk management mentioned above is as important today as at most any point in history. like us on facebook facebook.com/pages/ kingscountynews