Not all risk is created equal. Similarly, if you ask 5 investors what significant risk looks like, you'll get 5 different descriptions. In my trading career, I've gone through different relationships with risk. This is normal as our circumstances evolve. I want to share 3 questions I've found helpful in understanding how I felt about risk and how I used that information to inform my investing approach.
What is your objective?
Begin with the end in mind. Depending on what we look to accomplish, our risk will correspondingly take shape.
Want to make as much money as humanely possible in the shortest amount of time? We must accept significant risk.
Want to grow steadily but aggressively? Perhaps moderate risk applies here.
Want to reduce variance and maintain consistent returns? This sounds like a low risk profile to me.
Once we understand what we want to accomplish and postulate the associated risk, we can fact check ourselves. Originally thought you want to make as much money as humanely possible, but are uncomfortable with a prospective 80%+ drawdown or blowing your account up? Might need to revisit the objective.
Once you understand your objective, apply it to your risk assessment. This will serve as the primary guideline for how to structure a portfolio.
What is your time horizon?
This is the age old investing question - for good reason. Our timeframe matters tremendously. If you're attempting to aggressively grow an account, but expect to draw on the account in a year, you're likely setting yourself up for failure from the jump.
The adage of the longer your runway, the higher your risk tolerance should be, makes sense here. Consider your timeframe and apply that to your risk assessment.
How well do you understand yourself?
This is a trick question, because for most - it's not where near as well as we'd like to think. Most of us have an idealistic view of how we'd perform under pressure. How we'd react in crisis. How we allow bias to permeate into our analysis of data. Just how much thought is outsourced to our subconscious and just how biased our subconscious thought process inherently is. We must accept that until we've tested ourselves in similar conditions and have observed our actions, we don't really know what we'd actually do.
What's the next best thing in the meantime? To STUDY. There are TONS of great white papers on how investors and traders behave. What our tendencies are. Armed with this information, we can get to work overlaying our own assessment. This matters particularly for how we behave with winning and losing trades.
Most investors cut profits too quickly and allow losses to run too far. This has been studied extensively and poses a huge problem for being a profitable investor. Review your trade log - what does it show? ADJUST your controls to regain balance over risk and reward ratios and ultimately achieve positive expectancy.
Risk is good. We need risk. We also need to develop a thorough understanding of it and how we operate around it. Seek first to understand, than to be understood.
Be an Outlier!