Investing without Wall Street: The Five Essentials of Financial Freedom

CHAPTER 3

The Third Essential: Understand and Control Risk

The era where taking greater risks almost always got you greater gains is history. It died when the great secular bull market ended. In this new era, the importance of risk management in investing is vastly increased.

So even though the subject of controlling risk overlaps with asset allocation and diversification, managing risk is so important and has such unique aspects that, I believe, it warrants its own discussion.

The goal of this book is not to achieve the greatest gains; it is to achieve the greatest risk-adjusted gains.

Some losses are inevitable when you're investing. So, let's concentrate on avoiding an unaffordable loss, no matter how unlikely the circumstance.

Measuring Risk

Before you can protect yourself against risk you need to be able to measure it. After all, investing is not a gambling game where the odds of winning or losing can be calculated to the penny. Investing deals with multiple unknowns that are virtually impossible to measure. (There was a lot of anguish in 2008 and 2009 when federal regulators couldn't figure out the risk in the mortgage securities held by Freddie Mac and Fannie Mae.)

Basically, risk is simply the possibility of losing money, most importantly at the end of an investment horizon. But that's not precise enough for our, or Wall Street's, purposes. It's important to quantify risk to the best of our ability. So Wall Street has found a solution that provides us with the needed preciseness: ...