Risk management for investors [three blind spots and five actionable tips]

Even savvy investors have a few common blindspots when it comes to risk management:

• They believe that maximizing each year’s performance will also maximize their career’s performance,  but this is false. Maximizing yearly performance misleads one to take risks that are optimal over a one-year time frame but are suboptimal for a whole career.

• They overestimate the chances of success of their investment strategy “because everyone smart who used this strategy made money and I am smart,” neglecting that smartness can only be truly known post-hoc, so they do not know yet how smart they truly are.

• They model risk but do not consider risks their model might be blind to. The problem is not using models but their reliance as the only tool to assess risk. (We’ll see an alternative later on.)

• They consider investing risk but not other kinds of risk, such as doing business with a bad partner or neglecting their health or marriage.

Of course, plenty of other risks are relevant to investors, but those four are some of the most important yet under-discussed ones.

There is enough to say about risk management for investors to fill a book (and, in fact, I wrote two: “Ergodicity” and  “Winning Long-Term Games”), but here are a few tips:

• Do pre-mortems: imagine you suddenly find yourself with a 30% portfolio loss. What could have happened, and what can you do today to prevent it?
• Do pre-mortems, but for risks other than financial losses. Imagine you get sued. What could be the most likely reason, and what can you do today to mitigate it? More examples in this one-minute exercise to derisk your life.
• Use multiple models so that each one covers the others’ blind spots.

• Think about what risks your models might have left out. What do others worry about that you do not?

• Think about how other investors failed. Learn from the mistakes of others before they become yours.

The author, Luca Dellanna, is a senior risk manager with over ten years of experience helping organizations worldwide manage risk. He also teaches risk management and related subjects at the University of Genoa as an external lecturer and has published a few books on the subject, including “Ergodicity” and  “Winning Long-Term Games.”