It’s dangerously easy to be lulled into a false sense of security when equity markets are chugging along higher; and especially so when they have done just that for the past six years in a row.
Few people give thought to risk management when the winds are the markets’ back. However, this tendency is the root for irrational and damaging investment decision making. After all, sooner or later, there will be a steep and swift correction that catches most off-guard, and those without a risk management plan are going to pay dearly in every sense of the word.
We’ve preached the importance of having (and following) a clearly defined asset allocation strategy. Equally important, and just as overlooked, is having a clearly defined risk management plan.
Three Dangerous Misconceptions
What’s just as dangerous as not having a risk management plan is following one that is inherently guided by misconceptions. In an effort to aid investors in developing a meaningful strategy to protect their capital when the next bear market hits, and it will, we’re taking a page from Ben Carlson’s book, a respected finance blogger and seasoned portfolio manager.
In his recent post, Three Misconceptions About Risk Management, Ben points our attention to three of the most common, and might I add dangerously so, misinterpretations of what risk management really entails. Below is a summary of these misconceptions:
- Risk Management Requires Predicting the Future with Great Accuracy: Your risk management plan does not need to revolve around accurately forecasting the next move in the S&P 500. Instead, it’s better if you focus on mentally preparing yourself for a wide array of outcomes and thinking ahead of time how you might deal with each one. Rather than bogging yourself with predicting what’s next, you’re better off planning for the worst. Also, as dividend investors, employing a bottom-up rather than a top-down approach is another surefire way to alleviate the worry of predicting the future.
Be sure to read Why We Prefer Bottom-Up Analysis.
- Your Risk Appetite Does Not Change: Your willingness to take on more or less risk should not be a response to fluctuations in the market. Instead, your risk appetite should be rooted in your financial situation. That is to say, your risk profile should evolve with respect to important life events, such as a new job, a new house, an unexpected liability, rather than which way (and by how much) the market is moving.
- All You Need is a Risk Model: The notion that merely quantifying risk gives us a control over it is a dangerous misconception. While it is useful to have numerical values in mind when it comes to risk management – for example, how much might my portfolio decline in value if the market drops 25% – this is only half the battle. The other part of the equation is having a game plan for how you will react (if at all) should the hypothetical scenario play out.
As Ben puts it, “The best a risk model can do for the investor is point out where potential areas of risk exist, not how that risk will manifest and play out.”
The Bottom Line
If you haven’t already, ask yourself this – what will I do when the next bear market rolls around? Mental preparation is absolutely necessary if you wish to avoid irrational decision making during tumultuous times on Wall Street. Do not fall victim to your own emotions, instead, outline a plan for yourself for how to deal with the worst case scenario so if it does occur you’re not left scrambling or running for the exit along with the rest of the herd.
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