Risk is one of the least understood subjects in Investing. We all keep saying that it is the other side of returns and such vague statements, but there is no proof that we understand risk. Let us look at some myths regarding risk:
1. Risk Management means we must have an ability to SEE TOMORROW: Too many people think that risk management means that we should be able to predict where the market is headed. This obviously means we know the direction of the market, the speed at which it will reach a new destination, how long it will be there, when it will go up or down again…
Believe me like John Templeton says “I do not know anybody who knows anybody who knows how to time the market”. Seriously you need to know the long term trend of the market, and have a good UNDERSTANDING of the market, but the ability to predict the next trend is surely not needed.
2. Risk is NOT with a product, but with how your co investors will react to a given circumstance: The risk is with a product and at a particular price. Proctor and Gamble was LESS risky at a price of 1200 than it is today at 7200. This is simply because the PE has got higher.
3. Your Risk Appetite will remain constant: This never happens, because risk is a dynamic concept. Big institutions constantly analyze their need to take risk, their need to grow their corpus, need for cash flows, etc. However individuals do not pay enough attention to their risk profile. Many events – losing a job, having a baby, divorce, marriage of a kid, kid’s education, kid moving out of the house, etc. impact your risk profile. Pay attention to this and alter your portfolio accordingly.
4. A risk model will save you: A risk model is exactly what it says it is – a model. No business model or risk model can understand human behavior for long periods of time. In Economics we assumed that we have considered all the factors….and kept saying “other conditions remaining neutral” – this NEVER happens. Far more importantly we CANNOT predict how our co-investors will behave. It is clearly a survival of the fittest…
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