How Many Of Us Really Understand Risk?

Institutional Investor excerpted a little from Howard Marks from Oaktree Capital Management writing about risk. The article covers just about every aspect of risk and provides a little validation for some of the ideas I write about. The article is a must read.

Instead of dissecting the article I'll just add a couple of thoughts. The excerpt devotes very little to how people take their perception of risk and then mismanage it. Someone left a comment on a post of mine at Seeking Alpha that he has 40% in closed end funds. I don't know if closed end funds are new for this person or not but every few years there is the right type of negative event in the market that generally crushes closed end funds, unjustifiably so. A 40% weighting is a crushing waiting to happen.

Invariably, while things are going well, like now (on a price basis, things have been going well), no one says "oh yeah, the next time the market goes down a lot I am going to get caught with too much exposure to the wrong thing and I am going to panic sell big time." No, when things are going well people say "of course markets correct, everyone knows that, I won't panic."

No doubt the person with 40% in closed end funds thinks he has mitigated his risk and for all I know he may have somehow mitigated his exposure to more volatility than he really wants but this is a thing that too many people miss. To my way of thinking the time between the market cutting in half from 2000-2002 and then again starting in 2007 was short enough that more people should have remembered that the market can drop that much. This second decline was either the wrong type of volatility for people who don't need the money soon (mostly younger people) or the consequence of risk for people who need the money very soon (mostly those just then retiring) but either way people were shocked when the market went down so much and got caught very long many wrong parts of the market. This sort of thing is why I prefer an objective trigger point for defensive action. It requires far less insight than it does discipline.

Marks made one comment that is very similar to something I have talked about before that I don't see addressed very often. In my example I talk about the fictitious person who put 100% of his portfolio into Amazon (AMZN) the day of the IPO and sold at the April 23, 1999 peak. They would have made 5900% in 23 months. The person (we'll call him fictitious person number two) who bought from fictitious person number 1 with 100% of his portfolio lost 84% over the next 23 months. Hopefully it is obvious they each took the exact same risk. In one instance it worked out well and in the other it did not.

The key, I think, is first figuring your own tolerances (if you've been reading this site for a while hopefully you've done this some) and then figuring how to build a risk or volatility characteristic into your portfolio that you can live with but that still gives you a decent shot of having enough money when you need it. The sooner you can figure this out the easier time you'll have navigating the stock market cycle and hopefully you will achieve a better risk adjusted result.