# Managing risk when investing Unlike [other domains](safety-riskmgmt.md), investing treats risks as simply unpredictability, and it's *always* a part of investing. - Good risks are directly correlated with returns, but introduce progressively more uncertainty about those returns as the risks grow larger. - However, we tend to expect higher returns *from* those investments as they grow more uncertain as well. Most people tend to be more [afraid](mind-feelings-fear.md) about *losses* than unpredictability, but there are still bad things beyond simply losses: - Falling short of your [goals](success-3_goals.md) for an investment. - Under-performance of an investment. - Social risks from being [unconventional](morality-taboo.md). - Career risks if investing is how you make a living. - Illiquidity that may tie up your funds in assets when you need to use them for something else. People don't tend to consider their risks *not* connected with loss, which means they won't stay alert to *how* things can go wrong: - Correlations between prices can break, or even reverse. - Prices move overnight, and there might not be enough time to exit illiquid positions. - Rules change, and things might become illegal. - Rules change, and financial institutions/brokers may no longer invest in an asset from [breaking news](stories-storytellers.md). - People make typographical errors, and computer code that runs the transactions themselves sometimes has [bugs](computers-software-redesign.md). Loss and risk are a natural and mostly uncontrollable part of investing, so your ability to *not* react to it determines your financial state. - It's impossible to fully gauge risk because we can't know all the things that never happened. - We also assume things are risky when vastly unlikely things materialize. - Consider [praying about investing decisions](religion.md), since markets deal profoundly with [the unknown](unknown.md). When managed correctly, risks can be *extremely* profitable. - A large and likely enough return will offset any possible losses. - Only make 5:1 investments, where a $1 risk is worth gaining at least $5. - People tend to overestimate their hit-to-miss ratio, and a 5:1 investment means being wrong 4 out of 5 times (or 80% of the time) will break even. - One of the easiest ways to directly increase returns (and increase risk *nearly* but not quite as much) is to cut out the intermediate parties. - By removing the brokers and bankers, you take on more risk, but have a closer relationship with the money-making assets themselves. Generally, conservative thinking means your investments will stay steady with or slightly above inflation. Our [bias](mind-bias.md) means we tend to believe our "retirement money" is on the line. - All money is the same money: salary, gifts, savings, lottery winnings, dividends. - We tend to think our present money is more important to the future than that future money when we've made returns. - Most of our mindset about money comes from comparisons to other money (e.g., a $100 increase to $110 isn't as emotional to us as a $10 increase to $20). - Our emotional reactions are to the scope of gain or loss itself, and *not* to the domain of our actual financial position. - We tend to make dumber mistakes proportionally to how much we strictly trust our [intuition](understanding.md). - As a general rule, most people tend to keep losing investments and get rid of winning ones. - The decline in price is only indicated on paper, and only feels "real" the moment you sell. - For that reason, since you're feeling what almost everyone else is feeling, the smartest investing move is often to go *against* what you're feeling. - Don't pull out simply because the market dropped. - If we react to short-term drops, we tend to lose out on the productive days when our returns would be more significant. - Don't stay simply because you've already invested into it. - If the investment hasn't performed historically, you *need* clear evidence of a change to justify maintaining that investment. - Look only at the present state of the investment, and the future losses/gains it can provide, *not* what it has done in the past. We get more emotional proportionally to how frequently we check our investments. - *Only* check your investments when you want to change them. Don't assume a present windfall means you can re-gain it. - [Markets](economics.md) and opportunities change, [technology](technology.md) changes, [laws](legal-safety.md) change, and conditions today may be different from when you had made a gain before. ## Calculate returns Even in high-information markets like the stock market, professional investors [succeed](success-5_persevering.md) in the margins. - They'll buy a relatively stable asset for $30,000,000, then sell it later for $30,015,000. - Most of the time, they can use [computers](computers.md) to automate the task. Most [accounting ratios](money-accounting.md) apply to your investment decisions, but there are more that go beyond the specific entity. The Return on Investment (ROI) is one of the simplest ratios for calculation: - It's a quick, raw number to establish if the investment is even worth *thinking* about. - ROI = investment gain / investment cost When you have an investment's future value (FV), calculate its present value (PV): - It's used to discount cash flows in the future because you won't have that money during that time. - Present value = future value / [(1 + rate of return) ^ number of periods] Numerically, you can [measure an asset's risks](math-stat.md): - Alpha - take the price risk of something, then compare its risk-adjusted performance to a benchmark index. - An alpha of 1.0 means it's outperformed the benchmark index by 1%. - An alpha of -1.5 means it's performed worse than the benchmark index by 1.5%. - Beta - measuring the systematic risk of an asset compared to the whole market. - The market has a beta of 1.0, and the asset is measured on how it deviates from that. - A beta of 1.2 means it's theoretically 20% more volatile than the market. - R-squared - shows the percentage of an asset's movements that can be explained by movements in a benchmark index. - Values range from 0 to 100. - A performance record that's close to the index is 85 to 100. - Below 70, it'll typically *not* behave like the index. - For fixed-income securities and bond funds, the benchmark is the US Treasury Bill. - For equities and equity funds, the benchmark is the S&P 500 index. - It's not a good idea to invest in actively managed funds (see below) with high R-squared ratios because they're essentially performing like index funds, but with higher fees. - Standard deviation - the difference between the rate of return compared to the statistical average. - In finance, the standard deviation measures how much something is making higher returns than normal. - Sharpe ratio - subtracts the risk-free rate of return (i.e., US Treasury Bonds) from an investment's rate of return, then divides that result by the investment's standard deviation. - It indicates whether an investment's return is due to legitimately wise decisions or a result of excess risk. - Higher Sharpe ratios means better risk-adjusted performance. The Rule of 70 is a simple calculation to figure out how long it will take an investment to double: 1. Find the percentage growth rate for a period (e.g., 3%). - It's worth noting that this growth rate is projected, and very likely will be lower because of risks *nobody* can control. 2. Divide 70 by the whole number of the percentage growth rate (e.g., 70 / 3). 3. The result will be the number of periods it will take for the investment to double (e.g., 70 / 3 = 23.33). - 8% growth rate happens in 8.75 years (70 / 8 = 8.75). - 12% growth rate happens in 5.8 years (70 / 12 = 5.8). [Bonds](money-accounting.md) have their own specific ratios: - Current yield = bond's annual coupon / bond's current price - Useful to compare interest income by a bond to dividend income by a stock. - Nominal yield = annual coupon payment / bond's face value - Indicates the periodic percentage of interest that will be paid. - Yield to call (YTC) is rather complex and has computer programs for it, but it essentially gives the probability of the bond being called before its due date. - Realized yield is only for holding a bond for a certain period of time, rather than to maturity. ## Diversify whenever possible Spread your wealth across multiple assets and asset types whenever possible: - If you put all your wealth into one domain, you're exposing yourself to more risk. - Not diversifying creates more short-term gains, but will risk losing the entire portfolio. - When you can, spread it across industries and investments that are *completely* unrelated to each other. - It's easy to accidentally put money in indirectly related investments (e.g., healthcare and pharmaceuticals). One of your most important skills is in knowing *when* to risk *what*. - Your confidence should be finely calibrated to take reasonable risks while also avoiding overconfidence. - If you have a tendency toward overconfidence, place a numerical overconfidence discount into your financial projections. It's tempting to chase high returns, but focus more on diversity. - To be prepared, play out every likely scenario within your portfolio. Once you start making gains, your impulse will be to place more of your investments into that asset class. - However, while you *might* make more money, you're also risking losing it as well. - Keep at least 20% of your investment away from [trends](trends.md) you're currently capitalizing on. For maximum diversification, have a portfolio composed of the following: - 20% stocks, split across 3 generic index funds - 20% bonds - 20% currencies, cash, savings, and money market funds - 20% commodities - 20% other things like microloans, venture capital, and foreign investments - If you get real estate, you'll have to rearrange everything around it to accommodate it One of the easiest failures in diversifying is to have separate things that don't *feel* like they're related, but are the same thing. - If you're a [homeowner](home-maintenance.md), you're already invested in real estate, even if it's not giving any yields until you sell it. - If you're a [company employee](jobs-1_why.md), you're already a stakeholder of that company without owning any stock (i.e., you'd be [unemployed](hardship-unemployment.md) if the company failed. Periodically rebalance your portfolio. - Naturally, some investments will give better returns than others, meaning they'll be a higher percentage of the entire portfolio. - Keep your risk low by never letting an asset class stray to more than 35% of your investment. ## Leveraging By [borrowing money](money-2_debt.md) to invest, you're *not* making a better investment or increasing the chances of gains. - All you're doing is magnifying the gains and losses that may materialize. - If your portfolio fails to satisfy a [contractual](people-6_contracts.md) value test, the lenders may demand their money back when the investment is lower than you want. - You'll always owe the money, but you won't always be able to *get* the money from others (even when their loans are technically safer than yours). Some people create *unbelievable* wealth by borrowing, but they're more often ruined. - The exponential extent of compounding returns will be offset by the compounding expenses that match it. - One of the most frequent ways they fail is through secondary [math calculations](math-algebra.md) (e.g., failing at ratios), which can be devastating when they assume more risk. If you operate strictly on a cash basis, you'll never go entirely broke. ## Expect disappointment Generally, our [bias](mind-bias.md) makes us believe we'd never commit others' past mistakes, and that *our* future is far more [certain](understanding-certainty.md) than it really is. - You will win some, you will lose some, but the losses will hurt more than the gains. - Most investors act quickly, so the very act of moving slowly on trades will oddly time your market movements compared to everyone else. Wise and reasonable investing, more than anything else, protects against *most* risks. - Most investing wisdom involves finding financial advantages that are less unlikely compared to alternatives. - However, there's *always* a chance you'll lose your money on any given investment vehicle. Don't look at any isolated loss or gain. - Each loss and gain is connected to part of a broader whole, and often a [learning experience](education.md). - Losses can easily become part of a [success story](success-1_why.md). - Most of the time, people who lose learn more than people who win, and their long-term portfolio will look significantly better. Like [sales calls](marketing.md), most investing decisions are failures. - We tend to fixate on specific losses when they become [popular news](stories-storytellers.md). - If you keep self-criticizing over failed investment opportunities: 1. Write down every single investment idea you've had for at least a month. 2. Store that list away for about a year. 3. Take it out and see how all your picks have done. 4. You'll likely find your nostalgia forgot the bad ideas you had. Don't rush your plans or set your expectations too highly. - Good investing spans decades. - Don't let [fear](mind-feelings-fear.md) kill your chances to make a decent return. - Your [philosophies](philosophy.md), [values](purpose.md), and [understanding](understanding.md) are more critical to successful investing than luck. ## Things to watch for Some things can be *very* risky, so take your time with them. ### Trends Observe the markets' large-scale [trends](trends.md): - Stock market index futures are essentially indicators that determine everyone's sentiment on the market. - History *very* frequently [remixes from the past](trends.md), so learn to detect [patterns](symbols.md) that happened decades ago. - Ignore the minute gyrations of the market, which is harder than it sounds. - We tend to get caught up in the emotional rush of a [well-marketed](marketing.md) product. - Investors' subcultures can often closely reflect the [fanatical originators of cults](culture-cults.md). - Generally, it's a good idea to sell when there's hype and buy when there's panic. At any given moment, a market trend exists as one of 4 movements, and you should have a plan for each one: 1. Prosperity: - Living standards are rising - The [economy](economics.md) is growing - Business is thriving - Interest rates are typically falling - Unemployment is declining - Stocks usually thrive the most 2. Inflation: - Consumer prices are generally rising (at least 6% annually) - The economy is slowing - Business is still thriving, but hesitant about their long-term plans - Interest rates are rising - Unemployment is holding steady - Commodities and stocks rise with inflation 3. Tight money or recession: - The money supply has slowed down - People have less cash than they expected to have - Business is struggling, and the weakest fail - Interest rates are holding steady or starting to drop - Unemployment is rising - Bonds, currencies, and startups thrive the most in a recession 4. Deflation: - Consumer prices decline - The purchasing power of money grows - Businesses are hit hardest - Interest rates have dropped dramatically - Unemployment hits dramatic highs - If it persists long enough or the government intervenes wrongly, it can become a depression - Foreign currencies and commodities survive deflation Look ahead at the future of the market. - Government decisions can dramatically slow or speed up market crashes, but they *always* happen. - It's possible to develop an intuition for what the public will likely do with enough observation and [understanding](understanding.md), and you should move in the opposite direction. Ask questions about the second-degree effects of market movements: 1. What is the range of likely future outcomes? 2. Which outcome you think will likely occur? 3. What's the probability you're right? 4. What does the public consensus think? 5. How does your expectation differ from the consensus? 6. How does the asset's current price compare with both your expectation and the public consensus? 7. Is that consensus too bullish or bearish? 8. What will happen if the consensus is right, versus if you're right? It's generally easy to see a market bubble arise *long* before it pops. - There will typically be a *lot* of publicity around that bubble. - [Influencers](power-influence.md) will advertise the product as [serving needs it was never designed to serve](addiction.md). - People who have no business investing will start putting money toward it. - Some people will treat it as a permanent fixture of society. - You can still capitalize on a bubble in the short term, but try to avoid long-term investments toward a [hot trend](trends.md). ### Large-scale events The best time to invest is when large-scale events happen. - Every natural disaster is an opportunity to fund rebuilding. - Every economic crash will make debt collectors (e.g., repossessions) flourish. - A collapse of civil society increases the need for personal security and healthcare. - For centuries, [war](people-conflicts-war.md) has been one of the most profitable ways to profit (i.e., invest in the military supplies, then invest in rebuilding). - However, war funding is *highly* risky because there's too much vagueness and misinformation to accurately understand anything. When markets drop, [your feelings](mind-feelings.md) are your enemy. - If you know how to [manage your personal finances](money-1_why.md), the market shouldn't scare you. - Hold on to your investments and wait for the market to climb again before you drop your investment. - After a market drops, the economy will usually start to grow again within a week. - Most people focus on risks, but savvy investors consider opportunities that crises create. - The amount of time the market climbs is *way* more than when it's falling! [Fear](mind-feelings-fear.md) will kill any chance for large returns. - When panicking or following a trend, you may make a devastating decision. - On the other hand, hoarding cash will erode your portfolio's value. If you want to beat conventional thought, bet on unlikely odds. - If you pay extremely low amounts for investments that are *really* unlikely (e.g., always bet on the last horse in the race) your comfort with that risk is more likely to find something everyone else was overlooking. - It's not a winning strategy at first, but when done correctly over *many* iterations can yield better returns than safer investments. ### Public narratives The public [narrative](stories.md) defines where markets travel. - It's our [natural bias](mind-bias.md) to [create order](understanding-certainty.md) even when something is *completely* [random](unknown.md). - The market is a random progression with a slightly upward slope over long periods, and that's all that anyone can say with certainty. - High past returns might indicate low future returns, and low past returns might indicate high future returns. - A pessimistic set of investors dampening a stock price can often influence a company to perform better. - An optimistic set of investors can often make a company grow complacent. - [Large trends](trends.md) tend to start with individuals ignoring their inner thoughts to listen to what others are doing. - Financial contagion is caused by us being *so* affected by what others think that we can spread misleading or false information rapidly across markets. - The crowd is often wrong over short periods, but the true value of the investment tends to win out in the long term. - For that reason, following the entire crowd is a generally good bet (e.g., index funds). Be careful with investment advice. - If you hear it's hot news, and you're not insider trading (which is illegal), you're probably one of the last to hear it. - People are *six times* more likely to act on "exclusive market information", even when it's not exclusive. - Fortune magazine's top stock predictions consistently lose out against the rest of the market. - Investing books often have as much [scientific rigor](science.md), proven tactics, and complexity as alchemy was a few centuries ago. - Most fantastically wealthy people who gained their money through investing were incredibly [lucky](unknown.md). - The best investing wisdom may come from what *not* to do, but those people would never have best-selling books. - Investor-targeted media panic is a sophisticated version of media outlets' [fearmongering](power-influence.md). - If a market moves by 1.3% in a day, it's less than 0.01%, but [journalists are paid to give explanations people want to read](stories-storytellers.md). - If anyone starts talking about an unprecedented, innovative thing, check if the market is overheated and pull out your capital. - Be *very* doubtful of people saying "it's different this time", since nothing is ever new. Look at what people are *actually doing*, not what they say. - If a financial advisor is giving advice, their money comes from somewhere. - Numbers are simply [measurements of what people are doing](math.md), and [they can be manipulated](image-distortion.md). - Being realistic is the best way to prevent following an overheated market into a crash. No matter how elite or prestigious it sounds, it's likely that many people will follow a popular media personality's recommendation, even though potentially [millions of others are doing the same thing](money-investing-risk.jpg). Nearly everyone who gives investing advice has something to gain when you take action on it: - Brokers make money on every trade transaction. - Many wealthy investors will advance an asset class (e.g., bonds, cryptocurrency) because they hope to [influence](power-influence.md) the public narrative enough to turn a profit. For reliable investing thoughts, follow quants (quantitative analysts) who numerically follow market trends. - Keep in mind that they're simply crunching numbers, and [can't predict the future](imagination.md). - However, most of them will *not* tell you their actual strategies, since they'd lose their competitive edge. Stick with what you know and are familiar with, *not* simply what someone recommends. ### Personal feelings Change your perspective regularly to [new points of view](mind-creativity-how.md) to avoid fear or mania. - If all the assets in a market were fairly priced (which comes with more [information](information.md)), nobody would gain or lose anything by trading. - Avoid focusing heavily on short-term success, and keep your mind on your goals. - If you need to, look back *years* to see where you've come from, or read about history on any subject you want from before you were born. - We quickly tend to forget the uncertainty we had *before* an event happened. When your [feelings](mind-feelings.md) run hot, doing nothing is a better policy than acting on what you're thinking. - It's easy to acquire a gambling mindset when trades start generating considerable returns. - Instead of perceiving a choice of rejecting or accepting, reverse that choice. - e.g., instead of deciding among investment options, figure out which one you'd in *no* way choose. The only way to offset our constant emotional reactions are to hope for the best and expect the worst. - We often act to mitigate regret later, but tend to over-calculate how much we actually regret. - Instead, work to make the wisest possible decision now, then vow to never have regrets about what may happen. - An imperfect decision is still often better than none. ### Scams The most frequent indicator of fraud is promising high return with low risk. - No matter how "secure" things like gold, silver, or cryptocurrency sound, they're still as volatile as [the human perception of value](values.md). - If an account seems to have a skyrocketing balance, it's probably fake. The best way to avoid scams is to educate yourself thoroughly before committing to anything. - Before speaking details with any investment advisor, make sure they have FINRA oversight. - Practice [healthy cybersecurity](computers-cysec.md) with all your computers, *before* logging into your investments, and make sure you're at the right website. - Don't trust someone who just because you're connected on social media. Avoid bad investing strategies and philosophies. - "Specialized" investing secrets the professional investors use. - While esoteric information can be useful, most of that information is on web searches and online references like [Investopedia](https://investopedia.com/). - Anyone who says you'll miss out if you don't invest now. Many people exploit poor investor education to create products that create zero returns, sometimes with 100% fees. - A timeshare is a [vacation rental](fun-vacations.md), not an investment. - A Ponzi scheme is relatively simple, but is difficult to track if they're not being clear with you: 1. Convince someone to invest $1,000. 2. Go to someone else and convince them to invest $2,000. 3. Go back to the first person and give them $2,000. 4. Repeat with everyone until you have tremendous wealth, then either leave the country and assume a new name or get caught by the government. - If the investors are becoming owners/sellers/marketers, they're putting their money in a [pyramid scheme](marketing-mlm.md). - A Section 770 or Section 702 is the portion of the tax code involved with [insurance](money-insurance.md). Annuities are simply another type of [insurance](money-insurance.md) vehicle. - Most insurance companies are using your premiums to invest into significantly higher-yield products for *themselves*. - They'll give you a guaranteed 3% rate of return for the rest of your life, but they're typically making 6% on it that you could make yourself if you took on a little more risk. - All the tax advantages are more sufficiently fulfilled with your own retirement account (e.g., SEP IRA). - If you're wealthy enough that you've maxed out your retirement accounts, *then* you can start considering an annuity, but at that point the per-unit value of each dollar is less, and you can afford it. Gold, silver, and platinum are commodities, so they only give a profit when sold. - Because of their extreme refining, precious metals would be difficult to exchange in the apocalypse compared to centuries ago. - Someone [advertising](marketing.md) for people to buy gold is only advertising because they're turning themselves a profit. - If you're [worried about the apocalypse](hardship-disaster-3_long-go.md), gold and silver are too highly refined to be tradable. - To invest against *that* possibility, buy an easily tradable and on-hand commodity that never spoils, such as hard liquor. Lottery tickets aren't an investment. - The chances of you winning are abysmally small, so you're only renting a dream. Brokered mortgage notes are necessary when banks refuse to lend to that person. [Blockchain](computers-blockchain.md) is a unique commodity of [encrypted](encryption.md), solved [math](math.md) problems. - Blockchain implementations are largely unregulated and have little legitimate government-recognized value. - Avoid blockchain for long-term investing, and be prepared to sell quickly. Most complex new investment vehicles largely benefit the people who create them. - Never invest in what you don't understand. ### Crimes You may not get taken advantage of within an investing environment, but stay [legally safe](legal-safety.md) to prevent unknowing criminal activity. The laws of each country and industry will vary wildly, but always avoid a few actions: - Don't trade on specialized information other people have told you (which is called "insider trading"). - You can trade on public information (news, news articles) and on your intuition, but don't buy or sell around the same time that someone told you a major event will happen. - Don't keep records of what you're doing, if there's any chance it happens to be insider information. - Never [lie](people-lying.md) about whether you plan to buy or sell, since it will mislead others and they can sue. - Avoid *anything* remotely criminal, even if it's not criminal but only may appear to be criminal to an uneducated person. - Make sure whoever handles your finances is accredited by all applicable regulations. - If you're going across countries, make sure *both* countries' regulations are satisfied. Even then, [everything everywhere can be securities fraud under the right judge](https://www.bloomberg.com/opinion/articles/2019-06-26/everything-everywhere-is-securities-fraud). - CEOs of public companies know more about the company than outsiders do, but they're technically committing securities fraud if they even own 1 share of that company's stock. - They tend to trade with 10b5-1 trading plans over a set period of time to (typically) convert their stock into fungible cash. - Board members of public companies know more about the company than outsiders do, but they're likely in violation of fiduciary responsibility if they own 1 share of that company's stock. Criminally [prosecuting](legal-safety.md) over securities fraud is difficult. - Someone can frequently misstate the truth, then say it enough times they actually believe it. - It's easy to legally prove that someone didn't state the truth, but *very* challenging to prove they [lied](people-lying.md). - A society that's free enough to allow private investing is also usually free enough that people can make [bad deals](people-6_contracts.md). - Further, there are numerous bad lawsuits because hiring a good lawyer at $250K to sue someone who *might* be blamed is *very* worth the cost if an organization loses $200M.