What’s your biggest weakness?

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You should always be asking yourself this question.

If brilliant investors like Ray Dalio or Warren Buffett got together, they wouldn’t waste time talking about their successes. Nope, they’d be way more excited to tell you how they protected their principal.

That’s one of the first principles used by Buffett (as well as his mentor Benjamin Graham). It’s also the key to successful long-term investing: above all else, protect your principal. Don’t lose money.

risk management

This is a form of risk management, as it applies to your investment portfolio.

You know what a risk is. You take one every day when you get behind the wheel of a car. It’s why you pay for car insurance. Whether you’re consciously aware of it or not, you take risks every single day of your life. Ideally, when it comes to important decisions, you’re also doing risk assessments to check if you’re taking the right action.

Let’s take a look at the Risk Management Process that professionals often use to evaluate risk and apply it to an investing scenario.

1) Identify Potential Exposures

What can hurt you? Let’s say you were super excited about investing in oil. The price of a barrel of crude oil is currently about $40, which is a long ways off the $100 a barrel price tag just over a year ago. You’re betting that energy prices are going to rise. After all, the current situation is untenable, right? The reason oil prices are so low is because of oversupply. Once the excess supply is worked out of the system, things should go back to normal…

But what if it doesn’t? What’s my downside?

When adjusted for inflation, it’s easy to see that this period of low oil prices is really not that weird. Between 1986 and 2004, for nearly two decades, oil was the same as – or cheaper than – what it is now.

risk management

The reason oil prices were so low then and the reason they are so low now is different. The nuances should be explored – it’s outside the scope of this article – but the takeaway is that oil prices can and have been as low as $20 a barrel. So…if you invest $40 in a barrel of oil, your downside is roughly 50%; it’s unlikely that the price of oil will fall to $0.

2) Measure Frequency and Severity

Going back to the oil example, we’d want to look at the history of oil prices.

  • Why do oil prices fall?
  • What causes them to stay low or rise?
  • Look at the frequency (how often something happens) and severity (how intense they are) of oil price crashes.
  • When they do fall, how long do they stay range-bound; i.e.: do they just stay within a narrow price band, not really breaking out in any direction?

If oil price crashes are followed by 2-year long stretches where the price just oscillates within a 5% range, then a savvy investor would be able to conclude that oil would not be a great investment. Buying now would mean that his upside is very limited (maybe a 5% upside) and his downside (50%) is high in comparison.

3. Examine Alternatives

If you’ve concluded that investing in crude oil is not the way to go on this play, then do you give up? Hellz naw. There might still be something there!
It’s time to examine the alternatives.

Perhaps, with further examination, you find that companies who specialize in oil exploration tend to do well in periods like this. Perhaps big oil companies invest in exploration for new sources of oil in times of stress. In that case it would serve me well to invest.

risk management
Or maybe you find that when oil falls, and continues to be range-bound, that gold just kicks ass. Who knows? This is your chance to come up with as many alternatives as you can.

4. Decide Which Alternatives to Use

Simple enough. Figure out what strategy is the best; what gives you the most upside with the least downside.

Once you know that, you could even go through the process again to manage the downside risk of your chosen alternative. So, say you go with a gold investment. What’s the downside of investing in gold and what steps can you take to mitigate that risk? This is essentially just another way to think about diversification.

5. Implementation

Take action. Put your plans into motion. Sign up for that online investment account, put money in there and do what you set out to accomplish. How will you implement your plan?

Remember: a plan without action isn’t really a plan at all. It’s a dream.

6. Monitor

The easiest part. Sit back and check in on your investment every quarter. If you read the article on building a superstar portfolio, then you know how important it is to think about what you’re going to if your investment loses or gains value BEFORE it’s time to review it.
Is the investment consistent with your goals and needs? Consistent monitoring will ensure that there are no nasty surprises.

Always ask yourself: what’s your downside?

To learn more about risk management, head over to Wall Street Survivor

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