Classic: Ways to Cut Risk by David Merkel, CFA of Aleph Blog

This was published in 2004 at RealMoney.  I don’t know exactly when.

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I came into the investment business through the back door as an actuary and a risk manager. For more than a decade, I worked inside several large life insurance companies creating investment products. My team’s dirty secret? We just wanted to clip a smallish profit on the assets, without taking much risk ourselves. If we could do that, and produce a reliable investment result for our clients, we were happy.

That was my job then; in a different sense, it is my job now.  My goal as a writer, commentator, and independent money manager is to take much of the risk out of personal investing while retaining most of the profit potential.

Nobody can avoid every up and down in the market. What you can do, however, is to ensure that you don’t get crushed when the market rolls over. My own portfolio is a case in point. Over the last seven years, starting in September of 2000, my investment process has yielded an annualized return of 20% a year.  I manage to a long horizon, so I don’t try to cut losses in the short run.  I am willing to take pain if I feel that the underlying fundamentals are intact.  I had only one losing year in that time, but it was a doozy. During four months in 2002, my portfolio lost 32% of its value.  I was shaken, but I scraped together my spare cash and invested. Over the next 16 months, my portfolio rallied 86%, which I found about as astounding as the 32% loss.

The experience taught me that risk control works. Oddly enough, though, risk control doesn’t get a lot of attention. The most popular books and websites on investing spend nearly all their time focusing on the prospect of big returns; they rush over the matter of how to avoid big losses or how to deal with these losses when they happen. The result? Many people sour on investing because they take risks they don’t intend and lose a lot of money. They conclude that the investment game is rigged against them and they leave investing.

 

It doesn’t have to be that way. Let me suggest five simple ways you can control your worst tendencies, reduce your risk and become a happier investor.

Spread your bets around. The most basic rule of risk control is to diversify your investments. It is also the most neglected rule.

Perhaps the neglect is because most people don’t understand what diversification means. For starters, it means building a buffer against all the stuff you would prefer not to think about—unemployment, sickness, a horrible bear market, etc. Before you start investing, you need three to six months of living expenses set aside in bank deposits, money market funds and short-term bond funds. Having this cushion protects you from having to sell investments in an emergency, which in turn allows you to take risk with your remaining assets.

On top of your emergency funds, your portfolio should include a dollop of high quality bonds that mature in anywhere from two to 10 years. For older people, bonds cushion the downside of the total portfolio and ensure that you can’t be devastated by a stock market downturn. For younger people, bonds provide an additional benefit—you can sell them to buy stocks or other investments if the market plunges and you spot tempting bargains. So how much of your portfolio should you devote to bonds? As little as 20% of your portfolio if you’re in your twenties and a risk taker; 50% or more if you’re above 65 or naturally cautious.

Once you’ve got your emergency funds and your bonds stowed away, it’s time for stocks—and, once again, diversification should be your starting point. You don’t want to bet your entire future on a handful of stocks or on one industry or even on a single country. The easiest way to ensure that you’re widely diversified among many different stocks is to invest in a mutual fund or exchange-traded fund that holds scores of individual stocks, representing a multitude of different industries.

If, like me, you prefer to buy individual stocks, you have to balance your desire to be widely diversified against how much money you have to invest and—just as important—how much time you have to spend researching companies. My minimum for reasonable diversification is 15 stocks. When I started investing as a serious amateur back in 1992, I started with 15 stocks in my portfolio, and I bought $2,000 of each of them. Since then I’ve made maybe a dozen serious investing mistakes, but because I had my money diversified among many companies, none of my mistakes ever cost me more than 2% of my total capital.

These days I’m even more diversified: I run with 35 stocks, which is close to the maximum an individual can hope to track and research. Generally I devote an equal amount of money to each of my stocks—an equal weight, in investment jargon—because usually I can’t tell what my best ideas are. When a position gets more than 20% away from its target weight, I consider whether I should bring it back to equal weight or sell the whole thing.  Occasionally I deviate from equal weighting, but only when I have a very safe stock that is grossly undervalued. I never go above a double weight, which means that a single stock rarely accounts for even 6% of my overall portfolio.

 

The final way I diversify my portfolio is intellectually. I try to listen to as many viewpoints from as many different people as I can. I do this because the ideas of all but the most careful investors are internally correlated. They reflect some idea of what the economy is likely to do in the future, and they lean toward companies that fit that view. Some investors love companies with high P/E multiples and incredible growth stories. Other investors—and I’m one of them—love companies in distressed industries that are going for a song. You should listen to both camps. Doing so insures that you learn to think about investments from a wide number of perspectives. It makes investing more businesslike.

Here’s one trick you might find handy. As I gather my ideas from a wide number of sources, I print them out, and place them in a pile next to my computer.  I try to forget who gave me the idea, which forces me to look at the idea fresh, without the biases that come from trusting an authority figure.

Follow the cash. Most investors pay a lot of attention to how much a company earns; few investors realize how easily management can manipulate those earnings with fancy accounting. To reduce risk in the stocks you buy, keep an eye on a company’s cash flow as well as its earnings.

Your first step should be to look with a questioning eye at the non-cash, or accrual items, on the company’s financial statements. These include entries for such things as depreciation, inventory adjustments, or bad debt allowances. Cash is certain, but non-cash items such as these are anything but. Earnings can be thrown up or

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