Is risk management really important?
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Is risk management really important?
Issue #10
I don’t know if it’s just me, but have you noticed how stories of people getting rich go viral on social media? I’ve always wondered why stories of people losing everything don’t nearly get enough attention—not that I’m rooting for such stories. But whenever I come across such stories, I always think about something Morgan Housel says—getting rich and staying rich are two different things.
Money makes us do all sorts of really, really silly things and often brings out the worst impulses in us. I think one reason why a lot of people who get rich don’t stay rich is because of the galaxy-sized ego that comes with being rich makes them forget the importance of humility. People dismiss the role of luck and chance in them being rich and start attributing everything to their own genius. As Peter Bernstein once said:
Humility is an enormously important quality. You can’t win without it. Survival in the end is where the winners are by definition, and survival begins with humility.
There’s also another side to staying rich. Oh, and before that, being rich is contextual. It can range from having billions to having enough to lead a comfortable life with financial independence. It’s a personal thing.
How do you stay rich?
I personally think looking at why investors fail can be more insightful. At the risk of overgeneralizing, the one common thing in all the stories of genius investors going bust is taking too much risk and arrogance.
This begs the question, how do you become successful at trading and investing?
People talk a lot about strategies, stock picking, tools, psychology, etc and all those things are important. Perhaps the key aspect that gets the least amount of attention is the importance of surviving or avoiding the risk of ruin. Put another way, risk management.
Think about it, one big reason why a lot of investors and traders go bust is they take too much risk through poor position sizing, concentration, under-diversification leverage, etc. When the trades go wrong, they lose most of their capital and leave the markets. But if you listen to some of the best investors out there, they constantly highlight the importance of surviving. But people pay attention to what these investors invest in and not really to the important principles they talk about. Sad :(
But what is risk?
The traditional definition of risk is volatility and at a very simplistic level, volatility is just the degree to which prices move up and down. But I personally like the definition of Charlie Munger and Howard Marks—risk is permanent loss of capital. This feels much more intuitive to me. We live our entire lives trying to avoid regrets, and if you think about it, it’s the same with investing. We want to avoid losses at all costs, which is another way of avoiding regrets. It’s just that, we intuitively don’t think about it this way.
This great emphasis on volatility in corporate finance we regard as nonsense. Let me put it this way; as long as the odds are in our favor and we’re not risking the whole company on one throw of the dice or anything close to it, we don’t mind volatility in results. What we want are favorable odds. — Charlie Munger
The other important aspect that bears repeating is the markets are inherently uncertain. Thousands of factors can influence market movements, and this is precisely why predicting market movements is hard. So all you can do is control what you can control and make peace with the things you cannot.
How much risk you take and how you manage that risk is one thing you control. If you take outsized risks, have too much leverage, and have concentrated positions, you might make a lot of money, but you also run a high risk of blowing out. Making money and keeping that money are two vastly different things. But if you are sensible in how you take risks and just stay in the game, you can make money slowly and compound your money over time. Investors who are conservative often get judged for not taking risks, but the reason why conservative investors survive is they know when to take risks and when not to. They are ok with getting rich slowly.
The way to win in investing is by losing less. Seems counterintuitive, does it? Here’s how much money you need to make when you lose some from an old article Karthik had written:
For investors, ensuring you are diversified across stocks, bonds, gold, and real estate is the best insurance against the risk of ruin and stupidity.
Large losses are forever - in investing, in teenage driving, and in fidelity. If you avoid large losses with a strong defense, the winnings will have every opportunity to take care of themselves. And large losses are almost always caused by trying to get too much by taking too much risk. — Charles Ellis
There was a thoughtful Innerworth article on this aspect:
For novice traders, it is often vital that they control their risk (for example, risking a small percentage on each trade) so that they could survive long enough to gain mastery as a trader.
Very experienced traders who want to make greater profits need to start bending or breaking the rules a little to see if they can make greater profits and break through the barrier. This is risky, but some seasoned traders are willing to take the risk in order to make huge yearly profits. That said, they also can afford to take more risks. As seasoned traders, they have the methods and experience to take risks, but a novice trader does not. So even though there is no right or wrong way to trade, if you are new to the trading field, risk management has the advantage of allowing you to “survive the learning curve” until you find the once-in-a-lifetime opportunities to make you wealthy beyond your wildest dreams.
How do you avoid the risk of ruin?
One way to answer this question is in terms of the toolkit for traders and investors. Things like using stop losses, position sizing, diversification, portfolio optimization, etc. The other aspect is more psychological. It’s about knowing who you are and playing to your strengths. It’s about discovering tools and techniques that work for you and sticking to them like grim death. This only comes with some experimentation and experience.
But learning about risk management starts with understanding the foundational concepts. Of course, there’s a comprehensive Varsity module on that.
Having said that, all this is nothing new. A thousand people that are a million times smarter than some insignificant guy like me have said this time and again. But knowing something and doing something are two different things, especially in markets, where there's real money on the line and all our biases are on overdrive, making us do all sorts of funny things.
Varsity video series
As a trader, you'll have plenty of trades where you do a lot of homework and have the conviction that a trade will work, but it goes against you. This is the obvious risk of trading directional trades, where you are expecting a stock to either go up or down and trade that with options.
But you can also use certain option strategies that don't depend on the market direction and work regardless of how the market moves. Such option strategies are known as “delta neutral” strategies. In this video, we look at one such delta-neutral strategy—the straddle. Also, just because these strategies make money regardless of the market move doesn't mean they are without risks. We also look at the risks of delta-neutral strategies👇
वर्सिटी वीडियोस अब वर्सिटी यूट्यूब चैनल पर हिंदी में भी उपलब्ध हैं।
ज़्यादातर इन्वेस्टर्स उत्साहित होकर बोहत ओवर्क्राउडिड चार्ट्स सेट उप करलेते हैं जिनका कुछ प्रैक्टिकल इस्तेमाल नहीं है, इस वीडियो में हम देखेंगे एक सिंपल और सरल चार्ट्स सेट उप करने का तरीका जो आपको सच में ट्रेडिंग अवसर ढूंढ़ने में आपकी मदद करेगा। 👇
In tweets
If a stock is down 50-70%, more often than not, it means there’s something wrong with the company. People often say “Amazon fell 60-70%+ multiple times”. Sure, but for every Amazon, there are 1000s of stocks that became worthless.
But the one common thing we see time and again is that as a stock keeps falling, retail investors keep buying more. This was the exact story with Reliance Communications, Reliance Power, Yes Bank, DHFL, JP Group stocks, and countless other penny stocks. If you have to make money in investing, you need to buy businesses that are doing well and get rid of things that aren’t. But a lot of investors end up doing the exact opposite. Nithin tweeted about this recently.
Karthik tweeted a few things about trading
That’s all for this issue, and thank you for reading. Please do share and spread the word If you liked this issue.
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Is risk management really important?
Brilliant article as usual