5 Reasons Why Risk Matters In Investing

The Measure of Risk

Before I start, let us first be clear about the risk measure I am talking about. There are many different ways to measure risk… Volatility, VaR, downside risk, drawdowns, breaking them down into asset betas, and many more. Which one to use is debatable but definitely, none are perfect. And you can always look at more than one to get a more comprehensive picture. But for the purpose here, we will be looking at volatility and drawdowns. Because they are simple and useful.

1. Know How Much You Can Lose

Are you surprised that most people are ill-prepared to answer this question: How much are you risking? Or to put it from a layman’s perspective, how much do you expect to lose in say a bad scenario? This is different from how much you are prepared to lose. Anyone can quote a number on the latter based on their whims. But gauging how much you can lose is another matter. Some people can’t wrap a figure around that because they either have never bothered asking this question or have no clue how to estimate them. For quants, this would be inconceivable. If you don’t know how much you might lose, then you don’t know what you are doing.

2. Know How To Size Up Your Positions

How do you size your positions currently? Arbitrarily? Spread out the bets equally? In the hedge fund industry, we frequently sized based on risk. It is a sensible approach. Because risk is what is driving the returns. No risk no gain right? Some of you may already be sizing things up based on perceived risk. Perhaps, a key difference here is you might size based on more qualitative factors, while we sized based on a quantifiable and scientific basis.

3. Know If You Can Use Leverage

I am sure you read news about those who blew their entire account and more playing futures, shorting options, or dabbling in margin trading. The common thing here is the use of leverage. In simple English, leverage means borrowing more money, whether implicitly or explicitly, to size up your positions beyond what you have. Futures, options, or CFDs are instruments that come with embedded leverage. Margin trading, on the other hand, directly borrows money from the broker so that is explicit.

4. Stay Rational In Market Turmoil

Whether we like it or not, investing is a journey full of emotional ups and downs. Professionals are not spared as well. In a bad patch, tempers rise and curses fly. That’s pretty normal. But what sets good professionals apart is not what they feel but what they do to their trades. Unlike a lot of retail investors who will be overwhelmed with wild thoughts and hitting the panic button, professionals can resist such temptations.

5. Free From Market Timing

Timing the market is one of the favorite pastimes of many retail investors. And this is despite most not having the time, expertise, or information to make good decisions. As a result, many ended up buying high and selling low or missing the boat altogether. So effectively, they are often better off not timing or just going with some regular investment program riding on dollar-cost averaging.

Conclusion

The conclusion is straightforward. Risk does matter.

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