User-Friendly Risk Management

Initially, risk management may appear to be a complex, highly technical, and daunting discipline. However, once you become familiar with the “Risk-Wise” approach you’ll see how user-friendly, nontechnical, and effective it can be. The fact that you are now investing your time to gain insights and improve your knowledge level of the enormously important subjects of uncertainty, risk, and risk management is a very positive step. Quite simply, not being aware of or ignoring the critical role risk management plays in successful investing is itself a primary investment risk. So you should congratulate yourself for identifying that overriding risk, acknowledging its importance, and investing your time in gaining a better understanding of risk and risk management. Those few steps alone set you apart from most investors and serve as a key predictor of your future long-term investment success.

The principal objective of this book is to help you become a true “Risk-Wise” Investor. It is focused on helping you to better identify risks, to reduce the likelihood and impact of risks that do occur, and to turn risks into inconveniences and even potential opportunities.

What Is a “Risk-Wise” Investor?

The term “Risk-Wise” Investor refers to any investors with the power of judging their risk/reward decisions correctly, and following the soundest course of action based on broad knowledge, understanding, experience, and preparation . Those simple, nontechnical attributes are the foundation of the entire “Risk-Wise” approach. They are the key to better understanding risk, and the risk management methodologies discussed in this book. They are also the very same factors that helped you learn how to become a master of risk management in dealing with the risks you face in your everyday life. In fact, it’s a fundamental truth of human existence that we are naturally fearful of what we aren’t familiar with or don’t understand. So the more you know and understand about anything, the less fear, better decisions, and fewer missteps you’ll experience, and the more successful you’ll be. That is especially true of risks. In the heat of our fast-paced modern lives, and our fascination and dependency on technology, we may have neglected to apply what has been known about effective risk management for centuries. Almost 150 years ago the great thinker and writer Ralph Waldo Emerson articulated a key foundation concept of effective risk management that is just as valuable today. He observed: “Knowledge is the antidote to fear.” Since fear is integral to our natural risk management system, that insightful observation reinforces the fact that improving our knowledge of risk is key to reducing our fear of risk and to opening the door to better risk management and becoming less anxious, more comfortable and confident investors. When increased knowledge of risk is paired with deeper understanding and thorough preparation, risks are managed much more effectively and our fears and anxieties are dramatically reduced. Simply stated, and with very few exceptions, what we know, understand, and are prepared for cannot harm us.

This important precept is extremely valuable to “Risk-Wise” Investors today. It serves as a guidepost in the continuous search for better ways to identify, understand, manage, and control risks. This strategy is also just as effective in addressing the newly evolving, and sometimes frightening risks emerging from our rapidly changing, faster-paced, more interconnected, and less certain world.

In reading this book you’ll become familiar with the basic practical knowledge, understanding, and preparation methods you’ll need to become a more effective “Risk-Wise” Investor, including:

• Using a new empowering definition of risk to improve your investment success.

• Finding a time-tested way to reduce unpleasant, negative surprises.

• Reducing the severity of negative surprises, should they ever occur.

• Converting risks into “inconveniences,” and even potential opportunities.

• Improving your investment success by understanding your risk biology.

• Seeing where and how to best focus your risk management resources.

• Learning how to know which risks should you avoid, accept, or manage.

• Creating a personalized, systematic process to better identify, manage, and neutralize the risks you face.

• Managing ongoing, ever-changing, and new risks.

• Better navigating extraordinary crisis events, bear markets, frightening volatility, and extremes of the business cycle.

Again, congratulations! Once you finish reading and absorbing the contents of this book, you’ll know and understand more about uncertainty, risk, practical risk management, and how to implement it for your personal benefit than the vast majority of investors. You’ll become a more “Risk-Wise” Investor. That knowledge and those insights will serve you well. They will help you better identify, understand, prepare for, and manage risk. You’ll enjoy the greater peace of mind that comes from truly understanding what you are doing and why you are doing it, plus you’ll avoid many of the potential pitfalls and investment nightmares that can occur along the way. Best of all you’ll improve the likelihood of reaching your personal financial objectives, regardless of the investment environment.

Acknowledgments

The fact that this book was conceived in the first place, let alone completed is due the ongoing encouragement, support, and help of numerous friends, neighbors, and associates all over the country.

Enormous thanks are due to great friends John Riordan, John Nicholson, Rahoul Banerjea, and John Paolucci, whose continuous encouragement, questions, and comments helped me so much when I first became interested in researching and developing a user-friendly, nontechnical approach to understanding and managing risk. A tremendous debt of gratitude is owed to my friends and authors Jim Huguet for his sage counsel and educating me on the many issues facing a potential author, and Beth Birkman for graciously familiarizing me with the book publishing process, and for saving me an enormous amount of time and trouble in researching all that she was happy to share with me over a cup of coffee. Special thanks to wordsmith, author, and now retired risk management professional and consultant, Felix Kloman, for sharing his life-long passion for studying, observing, speaking, and writing about the multidisciplinary and ever-fascinating subjects of risk and risk management. His generosity in providing some key information on the history of risk management made my job much easier. Deep appreciation is also extended to friends and portfolio managers, Tom Goggins and Bill Hamilton, who shared their invaluable perspective as very experienced investment and risk managers. Thanks also to Jack Kenney, for his inspiration, counsel, and fine example of investment professionalism; Janice Reals-Ellig, for her encouragement; Dawn Kahler, for providing the efficient frontier studies; Todd Hiller, for his always thoughtful perspective and comments; and Ed Boudreau, for his suggestions and observations on risk management, from a private pilot’s viewpoint. Special thanks to former submariner Dave Wilson, Fire Chief Ken Willett, and Deputy Police Chief Barry Neil, for their insights into the unique challenges and risk management methods used by professionals whose job is to deal with life-threatening risks on a daily basis.

The deepest gratitude to my parents, Tom and Betty Carpenter, for their encouragement to always follow my dreams, and my brothers, John and Jim, and sisters, Cindy and Kim, for their love and unwavering support. Many thanks are also due to Nannette, Dean, and Ashley Carpenter, and Elizabeth Brodsky, for their technical help and support; senior management consultant, Paula Camara, for her always thought provoking questions and enthusiastic encouragement; and the extremely knowledgeable, helpful, and always friendly staff at the Boston Public Library and the library’s Kirstein Business Branch.

My appreciation is immeasurable for Tom Thomas and Dick Forbes, the two investment industry veterans who many years ago gave me the opportunity to first enter their incredible business, actually train on Wall Street, and build a career as an investment professional. I must also thank all the investors, financial advisors, and former associates, team members, executives, portfolio managers and consulting clients I’ve been unbelievably privileged to work with and continued to learn from over the years. You have made me feel truly blessed.

Last but not least, special thanks to Senior Editor David Pugh, Development Editor Kelly O’Connor, Senior Production Editor Michael Lisk, and Editorial Assistant Adrianna Johnson of John Wiley & Sons for their responsiveness, ideas, editorial assistance, professionalism, and help in making this book a reality.

CHAPTER 1

The Increasing Importance of “Risk-Wise” Investing

May you live in interesting times.

Ancient Chinese Curse

Our world, investment markets, and investing itself have changed dramatically in just the last decade. Investing has been irreversibly altered by a number of powerful, interrelated factors including:

• Enormous growth in the volume, availability, and instant dissemination of investment information.

• Unprecedented expansion of the number and types of investment vehicles.

• A dramatic increase in the sheer number of investors, domestically and worldwide.

• An explosion in the total size of investment holdings.

• Huge increase in investors’ interest in, and knowledge of, investments and investing.

• The ongoing and remarkable lengthening of human life spans, raising the stakes and critical importance of investing successfully.

• The increased global interconnectedness of all investors, economies, markets, countries, and continents, and their growing interdependence on one another.

• The accelerating pace of worldwide change and all the uncertainties it generates.

• Enormously increased market volumes and at times gut-wrenching volatility.

These historic changes have created wonderful new investment opportunities and new challenges. They’ve increased the likelihood and impact of old familiar risks and totally new types of risks when the stakes for what’s at risk are now even bigger. With those dramatic and continuing changes, understanding and managing risk is more important than ever before.

The Holy Grail?

Based on what we see, hear, and read virtually every moment of every waking hour, each and every day, achieving outstanding investment performance is the Holy Grail of investing. It’s held up as the foundation of investment success. Enormous time, energy, and resources are devoted to identifying and urging us to take advantage of the newest, hottest investment ideas, best performers, and the next big investment winners all over the world.

For instance, the media overloads and overwhelms us 24/7 with analysts, pundits, seers, and prognosticators (often contradicting one another). They urgently forecast economic and market moves for the next year, quarter, month, week, hour, day, and unbelievably, even minutes, so that we can rush to take advantage of their insights. Simultaneously, we’re experiencing an enormous explosion in the number of new investment vehicles, trading tools, and information sources. We’re also seeing a deluge of new active and indexed investments strategies, all designed to “help us” make more money on both the positive and negative price movements of almost everything. We now live in an investment world offering more distinct types of investments to choose from, and more and different ways to make or lose money investing, than ever before in history. As more sophisticated active and index investment alternatives attract more assets and compete more intensively with one another, the range between strong and weak investment performance is also shrinking.

The same phenomenon is occurring with private equity, alternative investments, and hedge funds as well as many other investment types. As more managers with more assets under management chase similar opportunities, the range of performance narrows and gradually reverts to a tighter range, more closely grouped around the mean.

The Game Has Shifted

There is another change that’s occurred in the investment world over the last 20 years, which has been overlooked by many investors. The nature of this subtle, but very important change was first pointed out by renowned institutional investment consultant Charles Ellis in his thought-leading book, Winning the Losers Game.¹ In his book, Ellis reviews why and how investing has shifted from a “Winner’s Game” to a “Loser’s Game.” He describes how the nature of the investment world has changed to now favor those investors who make the fewest mistakes rather than the investors focused on gaining the highest returns. He observes that the key driver of investing success has become similar to the success drivers in activities like golf and amateur tennis. In all these pursuits the winners win not by outplaying their opponents but by making the fewest mistakes. If you have ever played golf or tennis, you are undoubtedly familiar with this phenomenon, because the harder you try to win, the more mistakes you tend to make.

Investing changed to a loser’s game when large numbers of very bright people, with lots of resources, access to timely information, and lots of money to invest began competing with one another to achieve the best performance. The advantage now goes to investors who understand the benefit (using a baseball analogy) of the more consistent winning strategy of hitting lots of singles and doubles, getting on base regularly, and avoiding errors and missteps rather than having everyone of the team swing for the fence, attempt to hit home runs, and then strike out.

Ellis strongly emphasizes that the primary objective of investment management is risk management. Managing risk has always been important, but now emphasizing risk management and “Risk-Wise” investing is the most important investment success factor in achieving your long-term investment goals. Of course, this concept isn’t new or just limited to investing. It is also the fundamental core of the Hippocratic oath made by physicians for thousand of years: “First, do no harm.” Even real estate mogul Donald Trump has stated, “Protect the downside and the upside takes care of itself.”

That viewpoint is now also shared by the world’s largest business enterprises. In fact, the advantages of proactive risk management have become so important that within the last 10 years more and more large companies have created and staffed a totally new C-Suite level function focused on risk management. Adding to the long established positions of CEO, COO, CFO, CIO, CMO is the totally new position, and firm-wide department of the Chief Risk Officer (CRO). The underlying question though, is why? Why have these very sophisticated global enterprises felt the need to create a new senior executive position to oversee risk and risk management?

These multinational firms are placing such a big emphasis on risk management because they see and understand its tremendous value and realize:

• In today’s world almost anything is possible (both positive and negative).

• Today’s stakes have never been higher, and risk management never more important.

• Offense wins games, and defense wins championships.

• If something can happen, it typically will happen (often at the worst possible time) unless action is taken on it in advance.

• It is critical to be ready and prepared for any contingency, no matter how extreme.

These huge enterprises understand how much more efficient and ultimately less costly it is to invest time and effort in being proactive, prepared, and ready for risks. It’s much preferable to paying the enormous tangible and intangible costs of being caught off guard, being unprepared for negative surprises, and furiously scrambling around to recover from risks when some of them inevitably become reality.

If major worldwide corporations, with all their resources and capabilities, are now focusing on risk and risk management throughout their entire enterprises, isn’t it even more important for individual investors to do the same? Individuals investing for their own and their family’s future carry the full responsibility of their future quality of life and prosperity, and it is all riding on their understanding and effective management of the investment risks they face. So where do you go to gain that critical understanding of such a multifaceted, multidisciplinary, and important a subject as managing uncertainty and risk?

The New Way to Gain Mastery

The big challenge for most investors in improving their knowledge of risk and risk management is that the subjects can seem complex, confusing, and even intimidating. When the unpredictability of the future is also factored in, the entire process can seem overwhelming and almost fruitless. As a result, many investors either give up on the effort right away or lose interest over time when confronted with the challenge. They just don’t have the extra time to dedicate to educating themselves on the complexities of the subject, with all the other demands on their attention. Even investors who are fully committed to improving their understanding of the subject are often disappointed, because most sources of information on risk management either oversimplify the subject or offer varying forms of technical overload. At one extreme are the sources that discuss the subject of risk and risk management simplistically and skim over it much too lightly. At the opposite extreme are sources that elaborate on highly technical, detailed, quantitative approaches (the details of Modern Portfolio Theory, the Efficient Frontier, quantitative analysis, variance, alpha, beta, and correlation coefficients, standard deviation) that don’t resonate even with many sophisticated investors, unless they also happen to be engineers, mathematicians, or statisticians.

The single most important thing to remember is that for any risk management approach to work, you must not only understand how the method works, but also why it works, so that you can understand its strengths and weaknesses. It also helps if, through personal experience, you know that it works under a full range of environments and circumstances. Next you must have enough knowledge of and confidence in the method to believe it will work, and then fully commit to it.

The most critical point to keep in mind is this: Any risk management system that any investor uses and does not understand, or does not have confidence in, will not work. The reason it won’t work is because investors who don’t truly understand and have confidence in their risk management methodology will many times abandon it, at the worst possible time. As a result, there is an enormous need for a user-friendly, knowledge-based, easy-to-understand, and easy-to-implement risk management approach. A new middle way is needed between the extremes of oversimplification and technical overload. That new knowledge-based, user-friendly alternative is the “Risk-Wise” Investor method.

The “Risk-Wise” Investor approach is specifically designed to help you and investors everywhere build a strong, knowledge-based understanding of risk and risk management in a practical, user-friendly, nontechnical, and easy to understand way. It is designed to increase your knowledge and understanding of risk management, and your confidence in your risk management abilities. It will also help its users make better informed investment decisions, reduce the number and impact of negative surprises, and improve the likelihood of investors achieving their long-term investment objectives. What makes the “Risk-wise” Investor approach so easy to understand and use is that you have and are already using it, very effectively, in numerous aspects of your daily life.

Release Your Own Natural, Everyday Risk Management Power

You are a very successful Master of Risk Management. Although you may be surprised by that statement, and may not actually feel like an expert risk manager, you indeed are one. In fact, you are an accomplished and very successful Master of Life-Risk Management if you are a normal adult human being. You are a Risk Management Master because you successfully deal with all kinds of risks (big, small, and some life threatening) multiple times, every single day. Your risk management skills are so well developed that many times you use them unconsciously. Just think about the life-threatening risks you take just driving to and from work or going out for simple errands, every single day.

You started learning about risks and risk management when you were very young. You survived all the risks of early childhood. You learned some of your risk management skills from your parents and siblings. They taught you about a full range of risks you faced and how to manage them. Unfortunately, some risks you had to learn about the hard way, and even today you may still carry the physical and mental scars from those painful lessons. If you have been or are now a parent, you know how often and how quickly small children can unknowingly place themselves in highly risky situations.

You’ve survived and learned to successfully manage the many dangerous risks of adolescence and the challenging teen years, when your emotions and raging hormones overruled your logic and controlled your actions. You may even remember some former personal friends from those days who weren’t as good at risk management or risk decision making as you and as a result didn’t survive their teens. In fact, teenagers are such a documented high-risk age group that auto insurance rates for teenagers and young adults are significantly higher than any other age group, except for those people well into their later senior citizen years.

When you graduated into adulthood you faced many new risks and learned how to manage them as well. The key point is that as adult human beings, we are all Masters of Life-Risk Management and very skilled in dealing with life risks. Not perfect by any means, because risk management is never perfect and accidents and mis-steps do happen. Even then, because we are prepared, we have mechanisms in place to minimize the impact of those surprises and almost inevitable accidents.

In general, adult human beings have extremely well developed risk management skills that are very easy to take for granted. Have you ever driven home, pulled in your driveway or garage and realized you don’t recall making any conscious decisions on your drive home? It’s as if you were on automatic pilot the entire trip. What’s really quite fascinating are the responses you get when you ask most people to describe what process they use so skillfully to manage the life risks they face every day. Most, even after thinking for a moment, can’t describe their risk management process because they don’t know it. They don’t think about it. They just do it. Those individuals have internalized their risk management process so much and become so comfortable with it that they can’t articulate what it is.

What would it be like if you could reconnect with the process you use so effectively to manage everyday risks and apply that same process and those same impressive risk management skills in the investment world? You would:

• Better understand and manage risk.

• Make better, more knowledge-based investment decisions.

• Have more confidence in your risk management skills.

• Make fewer investment mis-steps and experience fewer negative surprises.

• Reduce the impact of the unpleasant surprises that do occur.

• Improve the likelihood of achieving your long-term investment goals.

• Be a happier more successful, less anxious, ready for anything “Risk-Wise” Investor.

The core of the “Risk-Wise” Investor method, and what makes it so different, is how it refamiliarizes and reconnects you with the very same process you have used in learning and developing your own everyday, and natural, life-risk management skills. It then provides you with a nontechnical, and easy to implement, step-by-step process to use in creating your own personalized risk management plan, and ongoing risk managed decision-making process. Let’s now review the steps in our everyday, natural life-risk management process and see how easily they transition into the “Risk-Wise” Investor method discussed in the next chapter.

CHAPTER 2

Introduction to the “Risk-Wise” Risk Management Process

If a man empties his purse into his head, no one can take it away from him. An investment in knowledge always pays the best interest.

Ben Franklin

What would it be like if you could be as accomplished and comfortable managing investment risks as you are managing the risks you face in your every day life? You’d make fewer investment missteps, and reduce the severity of the risks that did occur. You’d also increase the likelihood of achieving your financial objectives, and you’d be a happier, less anxious, more confident, more successful investor.

That’s the objective of the “Risk-Wise” Investor risk management method. My purpose is to show you how to use this user-friendly, easy-to-implement way to release your innate, natural, and highly developed life-risk management skills in the world of investments.

As adult human beings, we are all very accomplished, and very successful managers of the many risks we encounter in our everyday lives. Yet as comfortable and accomplished as we are with managing these everyday risks, we often feel quite uncomfortable and ill-equipped to manage the challenging and sometimes very painful risks of investing. Many investors have become so frustrated by their inability to effectively manage investment risks that they’ve come to see the investment markets as giant casinos, and investing as a crap shoot or game of chance. Although that’s not the case, those feelings of exasperation, frustration, and second-guessing our investment decisions are only natural. They result from the growing uncertainties generated by our increasingly faster-paced, rapidly changing modern world.

Frequently those feelings are further amplified by surprise crises, economic shocks, natural disasters, and geopolitical or economic turmoil. The added concerns generated by gut-wrenching market drops, and increased market volatility, which defy even the forecasting skills of the most experienced investment experts, can intensify those feelings to the extreme.

So what is the process we use to so effectively manage our everyday life-risks? Why and how can those same skills work just as well in the investment world?

That’s exactly what we cover in the rest of this chapter. We start by refamiliarizing you with your own highly developed life-risk management process. Then we review how to use the elements of that ingrained system as the foundation of your own, user-friendly investment risk management method, and close by introducing you to the basic steps of the “Risk-Wise” Investor risk management process.

Releasing Your Natural, Everyday Risk Management Skills

The more you become familiar with and use the “Risk-Wise” Investor risk management approach, the better you’ll understand and more effectively manage the risks you face now and in the future.

First, you need to refamiliarize yourself with the natural, step-by-step process you used in gaining your skill and comfort in managing everyday life-risk. However, that can be challenge for anyone; since by the time we reach adulthood the vast majority of us have internalized our risk management process so much that it has become automatic. We’ve become so comfortable managing life-risks; we do it on an instinctive level without even thinking about how we do it. In fact, when asked what process they use in managing their everyday life-risks, many people say that they don’t have a specific process. They just do it.

As such, I encourage you to take a moment right now to think through the steps you personally use in successfully managing the life-risks you face everyday. Then write those steps down. (Give yourself a little time to think about it and let it resurface, then write each step down in the spaces provided.)

Now, did the steps in your own risk management process come to mind easily, or did they require serious effort to recall? How successful were you in listing all the steps? How long did it take? If you are like most people, you found it surprisingly difficult for a process that you use so many times each and every day.

Although our bodies are hard-wired with many built-in, involuntary life-risk management systems (like our natural reaction to blink when something moves rapidly in front of our eyes or our instantaneous reflex reaction when we touch something hot), most of our life-risk management skills are learned skills. We learn them from our parents, friends, by watching others, and by ourselves.

Below is a quick review of the step-by-step process we humans use in learning how to so effectively manage the life-risks we face.

The Everyday Life-Risk Risk Management Process Steps

1. Identify Risks. Determine, and remember for future use those things that may cause harm or interfere with your physical health, goals, or objectives.

2. Understand Risks. Learn as much as you can about each potential risk, including its likelihood of occurring and its impact should it occur.

3. Review Risk Reduction/Risk Management Strategies Available. Become familiar with any and all strategies that can be used to avoid each risk, reduce the likelihood of a risk occurring, and minimize a risk’s impact should it still occur.

4. Evaluate the Risk/Reward Tradeoff (with and without risk management). Review the rewards of an action, or inaction, and the risk reduction options available to use versus the risks (likelihood and impact) of the potential action or inaction.

5. Make Your Decision to Act or Not Act. Once you identify and understand the rewards and the risks (likelihood and impact), have evaluated the effectiveness of the risk management strategies available to use, and have a full understanding of your risk/reward trade-offs, you then make your decision to either act or not act. You can then decide to avoid the risk entirely, act and accept the risk with risk reduction initiative(s) in place (reducing the risk likelihood and/or impact) or act and accept the risk with no risk reduction.

6. Implement your decision.

7. Learn and Adapt. Continuously learn from actual experience, then use what you learn to make better risk/reward decisions in the future.

Although these steps may at first seem simplistic, their ultimate risk management success is the result of each step building sequentially on the foundation of the one before to create a very powerful and effective risk management system.

Releasing Your Everyday Life-Risk Management Skills in the Investment World

As a result of its effectiveness and flexibility, you can apply that same basic, step-by-step, life-risk management process to managing investment risks, while paying special attention to some of the differences in managing investment risks versus real world, life-risks (Which we’ll cover in-depth soon.)

In addition, it’s very important to be patient with yourself. You gained your facility with managing life-risks over at least several decades. So remember, just like learning to do anything new, managing investment risks may initially feel a little awkward, cumbersome, and slow. However, the more you use it and repeat it, the faster, easier and more comfortable you’ll become. Then, over time, it becomes so automatic, internalized, and second nature, that you won’t even have to even think about it any more. You’ll just do it.

The Fundament Principals of “Risk-Wise”Investing

Before reviewing the “Risk-Wise” Investor risk management process it is very important to consider some basic facts about risk and its management. First, life, risk, and reward are inseparable, interconnected elements. In fact, just to live at all exposes each of us to numerous risks, not the least of which is day-to-day survival.

In discussing risk management, Walter Wriston, Former Chairman of Citicorp, Chairman of the Economic Policy Advisory Board for President Reagan from 1982 to 1989 and recipient of the Presidential Medal of Freedom said at www.online.citibank.co.in/portal/co/var.ppt: “All of life is the management of risk, not its elimination.”

This means that since it’s impossible to eliminate risk in life, we are all exposed to numerous kinds of risk whether we like it or not. As a result, since we can’t eliminate risk, we each must decide to either manage risks or be subject to their raw and potentially painful impact. Below are a few basic principals of risk management that are very important to keep in mind as you go about managing risk.

• Risk and reward are a normal part of life, of everything we do, including investing.

• Risk/reward trade-offs are integral to every decision, action, or inaction.

• Effective risk management is critical to long-term investment and life success.

• Risks can be managed, but never eliminated.

• You cannot effectively manage risk or uncertainty without understanding it.

• The more you know about risk and risk management the more effective you’ll be.

• Risk management will not work effectively if you do not understand how and why it works or have confidence in it.

• The most effective method of managing risks is to:

• Directly face risks.

• Become familiar with risks.

• Understand risks.

• Prepare for risks in advance.

When investing, the practical implementation of these risk management principles can best be achieved by using the same logical sequence of steps all of us use in our everyday life-risk management processes. The “Risk-Wise” Investor risk management method follows those steps, and in addition integrates into each step the special, unique considerations necessary for successful “Risk-Wise” Investing.

Building a Solid Foundation

Although the following process may at first glimpse appear simple and straightforward, don’t allow its simplicity to deceive you into underestimating its value and power.

Just because something is complex or quantitatively based, doesn’t mean it is necessarily better or more effective. Keep in mind what Benoit Mandelbrot, distinguished Sterling Professor of Mathematical Science at Yale University, one of the fathers of chaos theory, the inventor of the new field of fractal geometry (the geometry of nature), and extensive researcher of market price changes said in his excellent 2004 book The (Mis)Behavior of Markets. In discussing the efficient market hypothesis, which has been embraced by Wall Street, and become so popular with many academics, consultants, market analysts, and portfolio managers over the past 30 years, Professor Mandelbrot says, “Alas, the theory is elegant but flawed, as anyone who has lived through the booms and busts of the last decade can see.”¹

As with any successful multistep process, each step of the “Risk-Wise” process is built on the previous one. The quality and effectiveness of your end results, and the risk management benefits you enjoy will depend entirely on how well and how thoroughly you complete each preceding step. With each step in this risk management process being the foundation of the next step, the book devotes considerable additional time to familiarizing you with key information, valuable insights, and important facts you’ll find essential in effectively building a solid foundation at each step of the “Risk-Wise” risk management process.

The “Risk-Wise” Investor—Risk Management Process Steps

Now that you’ve refamiliarized yourself with the steps in your own, everyday, life-risk management system, and reviewed the fundamental principles of effective risk management, it is time to introduce you to how to apply those insights in managing the risks in the investment world. Once you become familiar with the “Risk-Wise” Investor approach and begin using it more and more, you’ll gradually find yourself becoming as accomplished at managing investment risks as you are managing the everyday life-risks you face.

The “Risk-Wise” Investor Process

1. Personal Risk Assessment

• Define risk (your definition of risk is the foundation of the entire process).

• Identify risks (you can’t manage a risk you haven’t identified as a risk).

• Understand risks (their likelihood and their personal impact should they occur).

• Determine which risks to avoid, accept, and/or manage.

2. Review risk reduction/management strategies available (their strengths and weaknesses).

3. Evaluate your risk/reward trade-offs (while avoiding common evaluation pitfalls).

4. Make your decision to act or not act—then implement it (while avoiding the common decision-making traps of many investors).

5. Effective ongoing risk monitoring and decision making (continuously being on guard for the emergence of new risks or threats and the evolving nature of known risks).

Building on this basic outline of the “Risk-Wise” Investor risk management process, the rest of this book will focus on how you can put each step of that process into action with extensive practical insights and valuable additional information that will help you build you own personal, customized risk management plan. We’ll review how to apply a new empowering definition of “risk” used by some of the top corporate chief risk officers (CROs) to your lifetime risk management and investment success. We’ll also discuss insights and lessons from the new field of behavioral finance and how to use them in avoiding very common risk/reward decision-making traps. In addition, we’ll cover a simple way to determine which risks you personally should avoid entirely, which risks to take and manage, and which ones to just accept.

On completing this book you’ll have also learned how to manage the full range of risks occurring in roaring bull markets; frightening bear markets; uncertain markets; and sometime the most challenging risks of all, the risks, traps, and pitfalls of our own, frequently flawed, decision-making biases. You’ll have everything you need to create and implement your very own customized, comprehensive, ready-for-anything investment risk management plan, and will be well on your way to becoming as accomplished and comfortable in managing investment risks as you are in managing your everyday life-risks.

CHAPTER 3

The Evolving History of Risk and Risk Management

Better to be wise by the misfortune of others than by your own.

Aesop

Of course risk and risk management are nothing new to human experience. They are as much a part of being human as living and breathing. Yet most of us know very little about how risk management has developed and evolved over time. So the very first step in improving our own knowledge and understanding of risk and risk management must be to become familiar with the history of this very important subject. Only then can we benefit from that knowledge in managing the risks we ourselves face today.

Rather than review the history of risk and risk management in detail, we’ll be taking a multidisciplinary, highlights approach. However, it can still benefit you greatly to study this very important subject in further detail. Therefore, I strongly recommend you read works such as Charles Kindleberger’s classic book on the history of financial crises, Manias, Panics, and Crashes, Peter Bernstein’s excellent history of risk, Against the Gods, and the classic, Extraordinary Popular Delusions and the Madness of Crowds, by Charles Mackay, and any of the many other fine books on the history of money, investing, and risk. You’ll be very glad you did.

Historical Highlights

In reviewing this chronology, you’ll also see just how our world is becoming both safer and riskier at the same time. This seeming paradox occurs because as we live with established and familiar risks we gain control and mastery over them, and gradually we become less concerned about them. However, the accelerating pace of change and the ever-more-interconnected nature of our modern world means that new, unfamiliar, and often frightening risks we’ve never experienced before can pop onto the scene to challenge our risk management abilities. Simultaneously, we can also very easily fall victim to overconfidence in our risk management abilities, let down our guard, and end up paying a very high price for erroneously assuming that some of our old, familiar risks were fully under our control.

This overview of the history of risk and risk management addresses the gradual evolution of our risk management knowledge and skills over time. It highlights examples of our triumphs over some risks, as well as instances where risks have surprised us, harmed us, and taught us how to better deal with them in the future. This review is divided into three general sections, each coinciding with the three main eras in the evolution of our growth in understanding risk, risk management, and uncertainty:

Part 1: A brief review of the ancient world through the Middle Ages.

Part 2: The pivotal role of the Renaissance

Part 3: The post-Renaissance period to the present.

This review is not meant to be a comprehensive study of the history of risk management but rather a quick, high-level overview of the growth of our knowledge of risk and risk management over time, better understanding, and a deeper knowledge of how we humans are gaining a better understanding of risk and how to manage it more effectively.¹

Part 1: The Ancient Past (Pre-600 B.C.)

The fragile, and challenging nature of the hunter/gatherer lifestyle of very ancient times placed enormous demands on the ability of people to survive from day to day. Often referred to as the Ancient Past, this period lasted until about 600 B.C. in most parts of the world. Listed below are a few insights into what life was like for humans during that ancient period of time.