Risk Management
How will your capital be protected
while pursuing market beating returns?

Risk is managed through diversification, rebalancing, calm reassessment
in the face of new information, and disciplined adherence to strategy.

Knowing which risks to accept and which risks to avoid will produce better returns along with a sounder night’s sleep. The keys for managing risk are knowledge and psychological discipline. Before discussing risk management, we must identify the main sources of investment risks.


Economic and Political Risk is the main source of real fundamental risks. Market supply and demand and the government policies that affect these are the major determinants of economy wide profits and therefore returns on investments. Changes in taxation, monetary policies or regulatory rules all can have significant effects on financial results across the entire market. Analyzing the implications of events and trends and investing accordingly is the most significant source of excess return compared to buying and holding an index fund. The impact of these fundamental factors is generally spread out over longer periods of time - as real world events play out.

Market risk is the day to day fluctuations in valuations that have more to do with market mood swings in terms of risk tolerance. I.e. the greed and fear factors that cause price to earnings ratios to change significantly without news to justify such changes. Let’s consider an example. Apartment Investment Management Co. is a real estate investment trust (REIT). Its ticker is AIV. REITs are valued based on a multiple of Funds From Operations (FFO). A multiple below 10 should produce a good return for the risk. On March 30th 2009 AIV closed at $4.99 per share which was 2.8 times projected 2009 FFO. On May 21st 2009 AIV closed at $9.25, up 85% in less than 60 days. Earnings came out and the 2009 forecast was unchanged - so the multiple rose to 5.1. Nothing happened, except that market participants felt less risk averse and so were willing to accept lower returns for the same risks. Thus they bid up stocks to higher multiples with no change in economic factors. The reverse is also true. Market-sentiment-driven valuation changes are the second major risk factor.

Psychological Risks: many studies have found that human psychology is a source of risk because investors’ emotions and biases cause them to make poor investment decisions. From 1984 through 1995, the average stock mutual fund posted a yearly return of 12.3% (versus 15.4% for the S&P), yet the average investor in a stock mutual fund earned 6.3%. That means that over these 12 years, the average mutual fund investor would have accumulated more than twice as much money by simply buying and holding the average mutual fund, and more than three times as much by buying and holding an S&P 500 index fund. {Cumulative returns: individuals = 108%, mutual funds = 302%, S&P = 458%} There is something in most people’s nature which compels them to buy high and sell low. This is just one aspect of psychological risks.

“Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ…Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” – Warren Buffet

Finally there are company specific risks. Individual companies may outperform or underperform their industry or the market at large based upon their particular portfolio of assets and the skill of management in formulating and executing plans to maximize returns on capital and shareholder value. Company leverage and risk management play an important role here and financial management expertise is very important.

Managing Risk

Our task is to manage these risks in such a way that we earn good returns for the lowest risk. The most important risk management technique is diversification – not putting all your eggs in one basket.

Diversification means spreading out your money so a single investment cannot cause a “significant” loss all by itself. We have three ways to pursue diversification.

risk management

While we must diversify, there is a downside to too much diversification. The more companies held, the less time an investor can spend understanding each business and the less likely you are to earn market beating returns. If you hold 500 stocks you automatically will get the good with the bad and you’ll get average returns. When you go from one holding to two you’ve cut you risks in half. When you go from two to four you’ve cut them in half again. As the number of holdings rises, the benefit from adding each additional company drops. Generally if you’re actively managing a portfolio you probably should not hold more than fifty positions; thirty, including some exchange traded funds should be your target.

Rebalancing refers to selling assets that have risen and investing in those that have fallen in value so as to hold the individual positions somewhat stable as percentages of the total portfolio value. Notice what this policy calls for: selling high and buying low. This is the most basic rule of making money. It's also the opposite of what most people seem to actually do. Discipline is needed because buying something that has been declining brings emotion (regret, fear) into the decision process. Likewise selling something that has been good to us can also go against our emotions.

We do not want to add to holdings of a declining stock when the decline is for a good reason. Thus, when new information comes out that causes a price decline, we must analyze the new information to determine if it changes the likely returns of the stock going forward. We must be calm in reassessing the situation. When emotion and panic drive the rest of the market, those who keep their wits make all the money!

Psychological risks require a disciplined strategy. Without a doubt your emotions are the biggest barrier to successful investing that you will ever face. We naturally want to follow past trends but the studies show that switching between strategies based on recent results (i.e. selling the lower and buying the higher) typically causes investors to underperform both strategies. Therefore, part of what Berkeley Investment Advisors can bring to investors is the fortitude to stick with a strategy through thick and thin until it pays off. We help clients stick to a strategy that is consistent with their investing horizon and goals and resist their urges to make investing decisions based on emotions. The price of pursuing a long run value investing strategy based on analysis is that we sometimes must endure periods of regret as the market cycle turns against the strategy. This difficulty is (in a sense) what causes the value strategy to work in the long run. If value investing were easy, everyone would pursue this and the long run advantage would be lost.

Further Reading on the connections between Risks, Psychology, and successful investing: