Wednesday, January 16, 2013

The Idiot's Guide to Risk Management

Let's talk about "Risk"
Day traders court short-term risk, buy-and-holders define long-term risk. 
Smart investors establish target weightings for assets in a balanced portfolio and rebalance as prices change. That way you always buy low and sell high.  
And if you don’t have time, you hire somebody smart to do it. How hard is that? — Garth 

There are many different types of financial risk, but they basically all boil down to the same thing, loss of money. 

The world is full of all kinds of idiots and fools, and they seem to have very different approaches to risk. Fools think idiots "court" short term risk, whereas idiots think fools actually define long term risk themselves. 

Idiots think they understand that the market's prime motive is to take your money, when you least expect it, and that all of your capital should be outside of the market at all times, except in defined high probability trade setups, with known (pre-defined or do not trade)  risk : reward parameters. By managing risk:reward carefully, it becomes possible to break even or even be profitable, whilst only actually winning as few as 1 in 3 trades

(Day trading) idiots do not kid themselves that they know what will happen further out than the next few days, nor even that they know that much in fact. Idiots are in no doubt that the markets are smarter than them, and would never try to pretend otherwise. 

Fools, on the other hand think they can foretell the future and make financial plans to capitalize on their visions. Fools take a view on the next few years in their opinion, and then buy things in the market, weighted according to their views on the world, and then basically just hang onto them and hope for the best.

Fools are therefore exposed to market risk continually, and what the market gives them today, it can take back again tomorrow, with a vengeance. Fools have to wait until the end of the year to add up how much everything went up or down along the way, and just hope the number is positive. 

Idiots in general much prefer to take one-off, small limited-loss bets, generally a maximum of 1-2% of the account size, and win 3-5% of the account size on one bet, even if it is only a one-in-three success rate on their idiotic gambling, because their idiotic risk maths says that  -1% -1% 3% =   +0.94% 

They then like to close out of the market with any profit intact, and know it will definitely still be there in the morning. Dumb, huh? 

The Fools think that "re-balancing" gives them an edge over the Idiots, and the Idiots think the Fools wouldn't know "rebalancing" if it bit them on the ass. 

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