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  • Writer's pictureNicholas Pihl

Managing Risk

Most people are familiar with the stock market, which consists of hundreds of publicly traded companies that are all on their own, individual growth journeys, but whose valuations tend to rise and fall in tandem.

The reason these investments are correlated with each other is because they are all impacted by similar macroeconomic factors like GDP growth, inflation, and interest rates.

As a rule, GDP growth tends to be good for their fundamental earnings and sales growth, while inflation merely tends to be good for sales growth but without necessarily leading to higher profits. Moreover, higher inflation tends to lead to higher interest rates, which is typically compresses stock valuations. So that the same company doing the same amount of business is typically worth less when interest rates are high than it would be when interest rates are low.

All of these factors are very hard to predict with any certainty, and even expert economists have a poor track record when it comes to predicting any one of these variables. Throw in the fact that stock market performance incorporates all of these variables in complex, also unpredictable ways, and you start to see why it's a bad idea to try to time the stock market. Not only are these variables mostly unknowable, but their relationship to each other is also, largely, unknowable.

The solution, I think, is two-fold, and focuses on the things that are knowable. At a macro level, you can make sure that your investment holding period is long enough to boost your chances of a favorable outcome. Historically, holding diversified equity (stock) investments for about 7 years has led to a favorable outcome the vast majority of the time, while minimizing the risk of catastrophic loss over that period. This works because year-to-year volatility becomes less and less significant compared with the underlying growth of the businesses.

The second key here is to focus on owning investments that minimize the risk of a disastrous outcome in which you lose all or most of your money permanently. Bubbles like the dot-com boom, excessive leverage like we saw in the run up to the housing crisis, commodity price collapse like we saw with the BRICs, as well as fraud and embezzlement (like Bernie Madoff's hedge fund)... Anytime you see your neighbor getting rich and being cocky about it, that is usually a good time to ask yourself, "how might this not go well?"

What I'm talking about here isn't trying to beat the market or anything like that, just trying to avoid the worst possible outcomes. It's nice to get great performance, of course, but you also need to be mindful of risk. The most important thing, after all, is whether you achieve the financial goals that are most important to you. Often, it makes sense to take less risk to make sure you get the things that matter most, rather than take too much risk and leave it up to chance.

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